The Operatioll and Effect 

of the Possessions Corporation 

System of Taxation 

Third Annual Report 

Deparbnent of the Treasury . 

June 1980 
The Operation and Effect of the 

Possessions Corporation System of Taxation 

THIRD ANNUAL REPORT 

LIBRARY 

FEB 1 71981 

·'tM 3:) J.1 

TREASURY DEPARTM£Nt, 

Department of the Treasury 

June 1980 

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

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

WASHINGTON 

30 JUN 1980 

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 third 

(1978) annual report entitled, "The Operation and Effect 

of the Possessions Corporation System of Taxation." 

A similar letter is being sent to Senator Russell B. 

Long, Chairman of the Committee on Finance. 

Best wishes. 

Sincerely, 

_. 

~..»~ 

' . William Miller 

The Honorable 

Al Ullman, Chairman 

Committee on Ways and Means 

House of Representatives 

Washington, D.C. 20515 

Enclosure 

.. 
I 

ERRATA 

~age 28, 2nd paragraph, line 8: The word •over" should be deleted. 

~age 43, 2nd paragraph, line 3: Forty-four percent of these retained 

earnings, or $3.3 billion, were held 

by pharmaceuticals, NOT forty-seven 

percent, or $3.5 billion. 

~age 47, 2nd paragraph, line 5: One half of total distributions, or 

$581 million, were attributable to 

the chemical industry, NOT the 

pharmaceutical industry. 

~age &4, 3rd paragraph, line 4: Dividend distributions by possessions 

corporations were $1.15 billion in 

1978, NOT $1.5 billion. 

~lge 67, 3rd paragraph, line 3: Collections under the tollgate tax 

amounted to $49.l million in the year ending Ju~e 30, 1978, which represents an effective rate of about 4.1 

percent, NOT 4.5 percent. ---

~&ge 71 , Note: Dollar amounts are in thousands. 
THE SECRETARY OF THE TREASURY 

WASHINGTON 

3 0 JUN 1980 

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 third 

(1978) annual report entitled, "The Operation and Effect 

of the Possessions Corporation System of Taxation." 

A similar letter is being sent to Representative 

Al Ullman, Chairman of the Committee on Ways and Means. 

Best wishes. 

Sincerely, 

~ 

~.»...: 

' 

The Honorable 

Russell B. Long, Chairman 

Committee on Finance 

United States Senate 

Washington, D.C. 20510 

Enclosure 

. William Miller 

.. 
Table of Contents 

Chapter 

1. Introduction and Summary . .......................... . 

2. United States and Puerto Rican Law 

I . Int rod u ct ion . . . . . • • . . . . . . . . . . . • . . . . • . • . • • . . . . . . 6 

II. United States Tax Provisions ................... 6 

A. Historical Background .......••.•...•...•... 6 

B. Present Law . . . . . . . • . . . . . . . . • . . . • • . • . . • • • • . • 10 

III. Puerto Rican Tax Provisions 12 

A. Historical Background ....•.•.....•••••.•.•• 12 

B. Present S~stem .............•....••...•.•..• 14 

3. Economic Development in Puerto Rico 

I. Growth Since . ................................. . 21 

II. Industry Composition of Employment ......•••..••• 21 

III. Underlying Factors ............................. 

4. Section 936--Tax Expenditure and Impact on 

Puerto Rican Business Operations 

I. Tax Expenditure 

24 

32 

A. General Considerations ..•....•........•...•. 32 

B. Current Estimates •..•......••••.....••••.•. 33 

II. Characteristics of Possessions Corporations .•... 36 

A. Information from S.E.C. 10-K Reports ••...••• 

B. Income Tax Return Information .•••••...•••.. 

C. Payroll and Employment Data •••..•••••.••••. 

D. Arthur D. Little Study •.•.•...•.•••.....••. 

III. Estimates of Linkages and Multiplier Effects •••. 

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

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

C • The Mu 1 t i p 1 i e r • • . . • • • . • . . . . . • • . . • • • . • . . . . • . • 

D. Direct, Indirect and Total Effects •.•...•.•• 

IV. Net Cost and Net Benefit ....................... 

36 

36 

47 

51 

53 

55 

55 

57 

59 

61 
a e 

2 

6 

6 

6 

0 

2 

2 

4 

2 

2 

3 

r 

1 

v. Impact of Changing from Section 931 to Section 

936 and of Recent Changes in the Puerto Rico 

Tollgate Tax and Industrial Incentive Program •.• 

A. Dividend Repatriation •••.•••.....••..••.... 

B. Federal Tax Expenditures and Puerto 

Rican Tax Revenue .•..........•...•••.•...•.• 

5. The Effect of 936 Funds on the Puerto Rico Capital 

Market 

I. Introduction . ................................ . 

II. Legal Background ••...........•..•.......•.•...•. 

A. Qualified Possession Source Investment 

Income Under Section 936 •..•...........•..•. 

B. Puerto Rico Tax Exemption of Eligible 

Income Invested in Certain Assets .•..•..•.. 

C. The Rules for Banks' Investment of 936 

Funds Effective Before April 1, 1980 ...... . D. The New Banking Regulations Effective 

April 1, 1980 ............................ . 

III. Empirical Analysis ............................. 

A. 

B. 

c. 

D. 

E. 

F. 

G. 

H. 

~pend ix 

The Inflow of 936 Funds and Net Capital 

Flows into Puerto Rico •...•••..•••.•••.•.. 

The Change in Bank Portfolios in Response 

to the Inflow of 936 Funds ••..•...••..•.•.. 

The Distribution of 936 Funds Among Banks 

in Puerto Rico .•••..••........•...•..•..•... 

The Interest Rate Differential 

Deposits and Regular CD's: Is 

for 936 Deposits Competitive? 

The Market for Loans in Puerto 

Much do Borrowers Benefit from 

Between 936 

the Market ............. 

Rico: How 

Low-Cost 936 

Funds? ••••..•••....•....•.••.•.•..••.•.•• 

The Puerto Rico Government and the Mortgage 

Market as Beneficiaries of 936 Funds ......• 

The Volume of 936 Funds in Puerto Rico: 

Can They be Absorbed? .....•..••.•...•...•. 

The Effect of the New Puerto Rico Regulations, 

Effective April 1, 1980 .••••.•...•.•....•.• 

A. Operation of the Possessions Corporation System 

of Taxation in American Samoa, Guam, the Panama 

64 

64 

65 

69 

74 

74 

74 

76 

79 

80 

80 

84 

91 

95 

100 

103 

107 

109 

Canal Zone, and the Virgin Islands ...•••....••.• 111 
B. Expenditures on Puerto Rican Inputs as a 

Percentage of the Value of Production, Selected 

Puerto Rican Industries ••..••.•.•.....•••••••.•. 1~8 

C. Historical Data and Sources and Limitations of 

the Data ....•..••..•.•..•.•.....•.•...........••. 134 
Figure 

I 

II 

III 

Table 

1 

List of Figures and Tables 

Total and Per Capita Gross National Product 

of Puerto Rico, 1947 - 1979 ••••••••••••••.•• 

Distribution of Puerto Rico Government 

Expenditures by Revenue Source, 1960 - 1979 

Tax Expenditure per Employee and Average 

Employee Compensation for Selected Industry 

Groups, 1978 ••.....•••.••.•.••••••.•...••• 

Federal Tax Expenditure Estimates and 

Projections, Possessions Corporation 

Provisions •......•••••....•••••..•••••.•••.• 

2 Puerto Rican Unemployment Rate and 

Distribution of Employment in Selected 

Pages 

22 

25 

50 

3 

Years, 1950 - 1979 •.••••..••••••••.•..••••••• 23 

3 

4 

5 

6 

7 

8 

9 

Distribution of Employment in Puerto Rican 

Manufactures, 1968 - 1979 •.••.•••..•••.•••••• 

U.S. Minimum Wage and Average Hourly Wage 

Rate in Manufacturing in Puerto Rico and the 

United .states •••.••.•.•••.•••.••••.••.••••••• 

Federal Transfer Payments, Grants, and Taxes 

"Covered Over" to Puerto Rico, 1968, 1978, 

and 1979 .................................. . 

Employment, Payroll and Value-added in 

Puerto Rican Manufactures, 1972 and 1977 

Major U.S. Manufacturing Corporations 

Indicating a Tax Savings under Section 

936 on their S.E.C. 10-K Reports for 1978 

Selected Balance Sheet Information by 

Industry, 1978 .•••.••.••.••••.••••.•...••••• 

Possessions Corporations and All U.S. Corporations: Net Property, Plant and Equipment as a 

Percentage of Total Assets, 1978 .••••••••••• 

26 

27 

29 

31 

37 

39-41 

42 
10 

11 

12 

13 

14 

15 

16 

17 

Selected Income Statement Information and Tax 

Expenditure by Industry, 1978 .•.•...••.•.. 

Tax Expenditure, Employment and Compensation 

of Employees by Industry, 1978 •.•••.•.••..•• 

Tax Expenditure, Employment and Compensation 

of Employees by Size of Tax Expenditure per 

Employee, 1978 ...........•........••..•.... 

Distribution of Employment between Skilled 

and Unskilled Occupational Groups by 

Industry in Puerto Rico, 1975 ....•.••••...•.. 

Destination of Shipments by Puerto Rican 

Manufacturing Industries, 1972 ..•..•...•..•.• 

Tax Expenditure as a Percentage of 

Compensation of Employees, of Total Direct 

Expenditures in Puerto Rico, and of Total 

Direct and Indirect Expenditures in Puerto 

Rico for Manufacturing Industries, 1978 .•.•. 

Possible Impact of Parallel Reductions in 

Federal and Puerto Rican Tax Benefits 

Provided to Possessions Corporations 

Elections under Section 936, by Industry 

18 Estimated Composition of the Financial 

Investments of Possessions Corporations 

44-46 

48-49 

52 

54 

56 

60 

62 

66 

at Year End 1979 . • • . • • • . . . • . • • . . • . • . . • • . • • • • 70 

18-A Estimated Composition of the Financial 

Investments of Possessions Corporations 

in Manufacturing at Year-end 1979 •..•••.••••• 71 

19 Net Capital Flows into Puerto Rico, 1970 -

1979 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 

20 Components of the Puerto Rico Capital Account. 82 

21 Consolidated Balance Sheet of All Commercial 

Banks in Puerto Rico on December 31, 1979 85 

22 Selected Assets and Liabilities of All 

Commercial Banks in Puerto Rico on June 30, 

1975, and December 31, 1979 • • • • • . • . • • . • • • • • 88 

23 Distribution of Bank Deposits in Puerto Rican 

Banks, December 31, 1979 .••.•••.•.••.•••.••.. 92 

24 Distribution of 936 Funds from All Sources; 

Average Daily Balances, April 1980 •....•••••• 94 
2~ Comparison of 936 and Regular CD Interest 

Rates .....•....•.....•..•.....•............ 97 

26 936 Deposits and Loans by Commercial Banks ••. 98 

27 Interest Costs on Bond Issues Sold •.••••••••• 104 

A-1 Income and Estimated Tax Expenditure 

by Possession ••.•.••..•••••.•...•••••••••••• 115 

A-2 Overall Tax Rates on Earnings Repatriated 

from the Virgin Islands and Puerto Rico 

A-3 Virgin Islands - Selected Income Statement 

and Balance Sheet Items, Tax Expenditure, 

122 

and Employment by Type of Corporation, 1978 124 

A-4 Virgin Islands - Tax Expenditure, Employment 

and Compensation of Employees by Industry •.•• 126 

A-5 Virgin Islands - Tax Expenditure, Employment 

and Compensation of Employees by Size of Tax 

Expenditure per Employee, 1978 •••••••••••••• 127 

B-1 Expenditures on Materials, Labor, Plant, and 

Equipment as a Percentage of the Value of 

Production by Manufacturing Establishments in 

Puerto Rico, 1977 ••••.••..•.•.•••.••.•.••••• 129-133 

C-1 Summary Data on Possessions Corporations, 

1973 - 1978 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 

C-2 Number of Possessions Corporations, Selected 

Income and Balance Sheet Items and Estimated 

TAx Expenditures, by Industry, 1977 ••.•••••.• 138-140 
-2-

CHAPTER 1 

INTRODUCTION AND SUMMARY 

This is the third annual report to the Congress on the 

possessions corporation system of taxation. Possessions corporations are companies incorporated in the United States 1/ but 

exempt under section 936 and related prov1s1ons of the U.S. 

Internal Revenue Code from Federal tax on income from operations 

in Puerto Rico, American Samoa, or Guam. 2/ Possessions 

corporations operate primarily in Puerto Rico, -where they are 

typically exempt from tax on 90-100 percent of their income. The 

percentage of their exemption will, however, decline somewhat 

over time, as provided by the Puerto Rico Industrial Incentive 

Act of 1978. 

Table 1 shows that the estimated Federal tax expenditure for 

the possessions corporation provisions was $826 million in 

calendar year 1978, and is projected to be $1 billion in calendar 

year 1981. Over 99 per·cent of this tax expenditure is 

attributable to Puerto Rico. 

The provisions and legislative history of the possessions 

corporation system of taxation are reviewed in Chapter 2. The 

treatment of possessions corporations under pre-1976 law and the 

changes made by the Tax Reform Act of 1976 are summarized. The 

1976 changes affected primarily possessions corporations' 

dividend pay-out policies and their portfolio investments, not 

the level of their real investment in Puerto Rico. Congress left 

intact the effective exemption from Federal tax on income from 

operations in a possession for the stated purpose of "assist(ing] 

the U.S. possessions in obtaining employment-producin9 

investments by U.S. corporations ••• " y 

1/ 

!:./ 

l/ 

Although Puerto Rico, American Samoa, and Guam are included 

in some definitions of the United States, for convenience of 

exposition the term "United States" in this Report inclues 

only the fifty States and the District of Columbia. 

Until October 1, 1979, section 936 also applied to operations 

in the Panama Canal Zone. 

General Explanation of the Tax Reform Act of 1976, page 274· 
Year Total 

1973 255 

1974 3b8 

b7!:> 44U 

H76 612 

1977 675 

1~7ti b2b 

b7~ 863 

1%LI 949 

1%1 l,u44 

l~ti2 1,149 

19d3 1,264 

l~tS4 1,390 

lYtsS 1,529 

-3-

Table 1 

Federal Tax Experrliture Estimates and Projections, 

Possessions Corporation Provisions 1/ 

(mill ions of dollars) -

Reduction in Calerrlar Reduction in Fiscal Year 

Year Tax Liabilities Tax Liabilities 2/ 

Companies O~ratin9 in: : Com12anies O~rati!!S in: 

:All Other U.S.: : :All Other U.S. 

Puerto Rico Possessions Total : Puerto Rico Possessions 

250 5 239 y 234 y 5Y 

362 6 289 284 5 

437 3 390 385 5 

602 3 492 489 3 

658 4 641 637 4 

822 4 743 739 4 

859 4 842 838 4 

945 4 902 898 4 

1,040 ' 4 992 988 4 

1,144 5 1,091 1,086 5 

1,259 5 1,201 1,196 5 

1,385 5 1,320 1,315 5 

1,524 5 1,453 1,448 5 

Office of the Secretary of the Treasury 

Off ice of Tax Analysis 

.!/ 'lhe 1973 thro1.gh 1975 figures are estimates based on book income data taken 

primarily fran election forms (Form 5712). The 1976and1977 estimates are based 

on net income data taken primarily from Federal income tax forms (Form 1120). '!he 

197tS figures are based on qualified possession taxable incane taken fran 

possessions credit computation forms (Form 5735). Figures for 1979 and all 

subsequent years are projections based on an assuned 10 percent growth rate. All 

figures are based on the assunption that in the absence of the μ:>ssessions 

corporation provisions, the incane of possessions corporations would be subject 

to an effective Federal corporate tax rate of 40 percent for 1973 to 1978, and 38 

percent for 1979 and all subsequent years (the statutory Federal corporate tax 

rate is reduced 2 percentage points -- from 48 percent to 46 percent -- beg inning 

in 197~) • For companies operatirg in Puerto Rico, the calerrlar year 1973 through 

1~7'1 figures are net of estimated tax payments to Puerto Rico; the figures for 

1Y79 and subsequent years are net of an assuned 5 percent effective Puerto Rican 

(corporate plus tollgate) tax rate on income of 936 manufacturing firms; 936 nonmanufactur irg firms are assuned to pay an effective Puerto Rican incane tax of at 

least 3b percent. Note that the section 936 credit, which applies in 1976 and 

subsequent years, is based on tax liabilities computed without regard to tax 

P~eferences, such as the investment tax credit, and without regard to Puerto 

~can taxes, which are taken into account in canputirg the tax experrliture 

figures. 'lherefore, the actual section 936 credit claimed will exceed the tax 

experrliture figure for the corresporrlirg year. 

Y Calc~at~. o~ the bas~s of normal relationships between calerrlar year corμ:>r ate 

tax 1J.ab11J.ties and fiscal year receipts. Fiscal years thro1.gh 1976 errl on 

June ~u of the corresporrling calendar year; thereafter on September 30. '!he 

transition quarter in 1976 is not shown separately. The receipts estimate for 

that quarter is $91 million. 

Y :fhlects in part reduced calerrlar year 1972 tax liabilities, which are estimated 

ave been lCJ percent lower than the estimates shown for 1973. 
-4-

To put the economic activities of possessions corporations in 

perspective, Chapter 3 provides a brief overview of the 

development of the Puerto Rican economy between 194 7 and the 

present. From 1947 to 1972, Puerto Rico achieved an average 

annual growth rate of 6 percent in real terms. Manufacturing 

rose from 9 percent of total employment in 1950 to 19 percent in 

1970, the same share that it provided in 1979. In the 1950's and 

1960's, the dual attraction of tax exemption and low wages 

induced large U.S. investment in labor-intensive industries, such 

as apparel, leather goods, and tobacco products. However, as 

Puerto Rican wages have risen relative to the U.S. average and 

structural changes in the world economy have increased the 

attractiveness to U.S. investors of low-wage foreign countries, 

the kind of firms investing in Puerto Rico has changed. Between 

1968 and 1979, there was a shift in the manufacturing sector from 

labor-intensive industries toward high technology industries. The 

unemployment rate, after declining to 10 percent in 1970, rose 

sharply to almost 20 percent in fiscal year 1977. Although the 

Puerto Rican economy has recovered substantially from the 

1973-1977 recession, with real GNP growing at an annual rate of 

roughly 5 percent in 1978 and 1979, unemployment stood at 17 

percent of the labor force in 1979. 

Chapter 4 relates the estimated tax expenditure on the 

possessions corporation system of taxation to the amount of 

employment and investment of possessions corporations in Puerto 

Rico. Largely because of the change in the industry composition 

of possessions corporations from the traditional, laborintensive industries to the high-technology industries -- the tax 

expenditure per Puerto Rican employee rose from $2,300 in 1973 to 

$12, 700 in 1978. As of year-end 1978, the book value of real 

investment in Puerto Rico by all 936 manufacturing firms was $1.2 

billion. Whether a scaling back of the possessions corporation 

system of taxation would actually lead to a reduction in Puerto 

Rican employment and investment and/or increased tax collections 

by the Federal or Commonwealth governments depends on how 

possessions corporations would respond to changes in the tax laW· 

The Tax Reform Act of 1976 1 imi ted a possessions corporation's tax exemption to income earned in the possession in which 

an active trade or business was conducted, with income earned 

elsewhere subject to the normal U.S. tax rates. The main effect 

of this limitation was to induce possessions corporations t~ 

1?ring to Puerto Rico the large pool of funds that had bee 

invested in the Eurodollar market. Chapter 5 expands thf 

analysis in previous Annual Reports of the impact of this pool 0

1 funds -- approximately $5 billion at year-end 1979 -- on rea 

investment in Puerto Rico. The Chapter first reviews the 

u 

m 

r 

g 

A 

a 

i 

h 

] 
-5-

U.S. and Puerto Rican legislation which determines the investments that are exempt from both U.S. and Puerto Rican tax. This 

review includes a description of the Puerto Rican regulations 

governing banks' use of 936 funds that were in effect before 

April 1, 1980, and also a description of the new regulations that 

are designed to remedy the shortcomings of the old ones. 

Chapter 5 then proceeds with a statistical analysis of the 

impact of 936 funds on investment in plant and equipment, 

housing, and inventories in Puerto Rico. It concludes that the 

large inflow of financial assets of possessions corporations 

after the enactment of section 936 had a virtually imperceptible 

impact on net capital flows into Puerto Rico. While there was a 

large inflow of 936 assets, there were offsetting flows out of 

Puerto Rico, mainly through the banking system. A review of the 

Ways in which banks in Puerto Rico have used 936 deposits, which 

amounted to 34 percent of all commercial bank deposits at the end 

Of 1979, finds that bank loans grew much more slowly than the 

rate of growth in assets made possible by the inflow of 936 

deposits. The impact of 936 funds on the market for Commonwealth 

of Puerto Rico debt is compared with the impact on the market for 

U.s. government-guaranteed securities backed by Puerto Rican 

mortgages (GNMAs) • The effect on the GNMA market was much more 

Significant because they normally carry a high yield similar to 

0 ther taxable issues, and the supply of Puerto Rican source 

GNMA's is small compared to the pool of 936 funds. The Chapter 

~oncludes that it will be difficult for Puerto Rico to absorb the 

arge volume of 936 funds because there will be a tendency for 

~one~ to flow out to areas with a higher rate of return. The new 

d

ank1ng regulations may, however, reduce this outflow to some 

egree. 

t· Appendix A of this Report describes the possessions corporat~on system of taxation as it affects American Samoa, Guam and 

e Panama Canal Zone. The tax exemption for U.S. corporations 

~~er~ting principally in the Virgin Islands is delimit~d by 

B ct1on 934, which was unaffected by the Tax Reform Act of 1976. 

s eca~se the Virgin Islands is also a possession, and because 

t ect1on 934 has many features similar to those of section. 93?, 

r~! taxation of u.s.-controlled companies operating in the virgin 

ands is also described in Appendix A. 
-6-

CHAPTER 2 

UNITED STATES AND PUERTO RICAN TAX LAW 

I. Introduction 

The possessions corporation system of taxation consists of a 

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

deriving most of its income from Puerto Rico typically pays less 

than 5 percent of that income in taxes to either Puerto Rico or 

the United States. The system is complex because, in principle, 

both the income earned by a "936" corporation and the dividends 

paid to its shareholders (typically a U.S. parent corporation) 

are taxable in Puerto Rico and in the United States. The Puerto 

Rican rules for exempting part or all of the 936's income from 

tax and for reducing the "tollgate" tax on dividends paid to a 

U.S. parent vary according to whether the 936 corporation was 

awarded an exemption grant before or after June 1978. Moreover, 

corporations with "old" exemption grants had the option until 

December 31, 1979, to petition to "convert" from total to partial 

exemption and be subject to tax under rules which differ from the 

terms of either the old or the new exemption grants. 

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 a dividend received from a 

wholly owned 936 subsidiary with a 100 percent dividends-received 

deduction, which removes the dividend income from Federal tax· 

The particular way in which the near total exemption from Puerto 

Rican and Federal taxes is structured directly affects the form 

and substance of a 936 's behavior, so these rules need to be 

described in some detail. 

II. United States Tax Provisions 

A. Historical Background 

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. citizens, residents 

and corporations. However, because the Puerto Rican rules have 

been fashioned to take maximum advantage of the Federal rules an~ 

have changed when the Federal rules have changed, the Feder a 

rules should be described first. 

( 

t 

I 
a 

>n 

! , 

s 

) 

0 

a 

s 

1 

e 

-7-

The predecessor of section 936 appears in the Revenue Act of 

1921. As first introduced into the House of Representatives out 

of the Ways and Means Committee, the bill exempted from Federal 

tax the foreign source . income of U.S. "foreign traders" and 

"foreign trade corporations," which were defined to be U.S. 

citizens and corporations, 80 percent or more of whose gross 

income was derived from foreign sources. The United States taxed 

the foreign income of U.S. citizens and corporations as it was 

earned, while English law deferred taxation on foreign source 

income until it was remitted to England. 1/ Thus, U.S. taxpayers 

doing business in countries that imposedlittle or no income tax 

felt that they were handicapped in their business competition 

with British rivals. The bill as originally proposed would have 

resolved this problem by exempting from U.S. tax the unrepatr iated foreign source income of "foreign traders" and "foreign 

trade corporations." '!:_/ 

On the floor of the House, the benefits of the "foreign 

trader" exemption were restr~cted to individuals and corporations 

Which, in addition to deriving 80 percent or more of their income 

from abroad, derived 50 percent or more of their income from "the 

active conduct of a trade or business without the United States." 

The purpose of this amendment was to target the benefits of tax 

exemption on U.S. businesses and make it more difficult for 

wealthy Americans with investments in foreign securities to 

Qualify as "foreign traders." 

l! A U.S. firm or a U.S. citizen abroad normally pays taxes to 

two countries: by virtue of its place of incorporation or 

citizenship, the taxpayer is subject to U.S. tax on its 

worldwide income; by virtue of the source of its income, it 

is also taxed by the host country. To relieve double taxation, the United States allows a dollar-for-dollar foreign 

tax credit against U.S. tax on foreign source income, so that 

in effect the taxpayer is subject to tax at a rate which 

equals the greater of the foreign tax or the U.S. tax on its 

foreign source income. In contrast, a British corporation or 

expatriate citizen deriving its income from a foreign country 

was normally subject to tax only by the host country as long 

as that income was not brought back to Great Britain. 

~/ Under U.S. law, foreign incorporation also defers the taxation of foreign source income until profits are remitted to 

the U.S. 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. 
-8-

When the 1921 Revenue Bill was introduced in the Senate, the 

"foreign trader" exemption was struck. Many Senators could see 

no reason to depart from established national policy of taxing 

citizens and domestic corporations based on their ability to pay, 

regardless of the source of their income. Various Senators 

stated that while there might be some reason to promote U.S 

exports, there was no reason to promote U.S. foreign investment, 

since that would increase employment and wealth abroad at the 

expense of jobs and development in the United States. Moreover, 

the exemption created vast opportunities for tax avoidance since 

any individual or firm having a large foreign business could 

organize a separate corporation for the foreign business and 

ensure that 80 percent of the profits of that corporation were 

derived from foreign sources. 

The strongest pressure for the exemption came from U.S. firms 

and citizens doing business in the Philippines, which at that 

time was a possession of the United States. To protect those 

interests, the Senate Finance Committee reintroduced the 

exemption in a form which reduced its coverage from all "foreign 

traders" and "foreign trade corporations" to individuals and 

corporations deriving 80 percent or more of their gross income 

from a U.S. possession. When the provision reached the floor of 

the Senate, various Senators proposed to extend the exemption 

also to taxpayers who met the 80 percent gross income test in 

China. Supporters of the exemption argued that it wou~d 

encourage U.S. export trade to the Far East from the U.S. base in 

the Philippines and would encourage U.S. business with China. 

One Senator expressed his opinion that: 

"All the amendment means is that an American doing 

business in the Philippines or Puerto Rico or in China 

shall not be compelled to pay two taxes, while the 

British merchant in Hong Kong or in Shanghai doing the 

same business is only compelled to pay one tax." 1/ 

As finally enacted in the Revenue Act of 1921, the exemption 

covered all foreign source income of individuals and corporations 

which met the 80-50 gross income tests in a possession other than 

ll 61 Congressional Record, p. 6997. 

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-9-

the Virgin Islands. 4/ However, dividend payments received from 

a "possessions corporation" by a U.S. shareholder were taxable to 

the shareholder. The effect of these two provisions was to defer 

U.S. tax on the foreign source income of a possessions corporation until it was repatriated. A possessions corporation was 

taxed under the U.S. law of 1921 as if it were a foreign corporation, and received the same benefits of tax deferral as enjoyed 

under British law by its British rivals in the Philippines and 

elsewhere. 

The possessions corporation exemption continued unchanged 

from 1921 until 1976. Between 1973 and 1976, the Ways and Means 

Committee held extensive hearings on the subject of tax reform. 

The Committee considered repeal of the possessions corporation 

exemption on the grounds that its original purpose, to expand 

U.S. trade with the Philippines and the Far East, was no longer 

being served as the Philippines had ceased to be a U.S. possession. However, proponents of the exemption argued that the 

Possessions corporation system was "the backbone of Puerto Rico's 

development." 5/ Many U.S. firms had established plants to avail 

themselves of tax exemption provisions enacted by Puerto Rico in 

1948, and these tax-exempt firms were a primary source of jobs in 

Puerto Rican manufacturing industries. It was argued that the 

Possessions corporation system of taxation counteracted the minimum wage requirement, the requirement to use U.S. flag ships in 

~ransporting goods to the United States, and other Federally 

imposed requirements, and that through the possessions corporation system could Puerto Rico compete with neighboring countries as a site for U.S. investment. Finally, it was argued that 

the possessions corporation system cost the Federal government 

!I 

S/ 

Why U.S. corporations doing business in the Virgin 

Islands were denied the benefits of the exemption is not 

explained by the Congressional Record. Congress in 1921 

also denied the benefits of this exemption to U.S. taxpayers in China, pending consideration of a second bill 

dealing only with China. As enacted in 1922, the China 

Trade Act exempted qualified corporations from U.S. tax 

on income from China, Hong Kong, and certain neighboring 

areas. This exemption was phased out by the Tax Reform 

Act of 1976. 

ELb_ic Hearings before the Committee on Ways and Means, 

use of Representatives, 94th Congress, 1st Session, p • 

.,.54. See also Public Hearings before the Committee on 

Ways and Means, House of Representatives, 93rd Congress, 

Tst Session, March 30 - April 2, 1973, pp. 4447-4451. 
-10-

only $200 - $300 million a year in tax expenditure, 6/ a small 

price in comparison to the $2 billion spent by tne Federal 

government in direct grants and transfer payments to Puerto 

Rico. 21 

B. Present Law ~/ 

Under present Federal law, a possessions corporation must be 

a U.S. corporation and for the three most recent years have 

derived 50 percent or more of its gross income from the active 

conduct of a trade or business in a possession and 80 percent or 

more of such income from sources in a possession:- A corporation 

meeting those conditions may elect the benefits of section 936. 

The election may not be revoked for 10 years without the 

permission of the IRS; as long as the election is in effect, the 

936 corporation cannot join affiliated domestic corporations in 

filing a consolidated return. 21 

A corporation meeting these requirements may claim a credit 

equal to (and, thus, fully offsetting) the U.S. tax attributable 

to: 

.§./ 

21 

~/ 

21 

In January 1976, the Federal tax expenditure as a result of 

the possessions corporation system were estimated at $285 

million on the basis of the limited data then available. 

(See the Special Analysis of the Budget of the United Stat~ 

Government for Fiscal Year 1977, "Special Analysis F, Ta_! 

Expenditure," January 1976.) When tax return data on possessions corporations became available as a result of a filing 

requirement enacted in 1976, the FY 1977 tax expenditure 

estimate was revised, from $285 million to $663 million. AS 

indicated in Table 1 above, the estimate based on the 1977 

returns is $641 million. 

See Table 5 on page 29 below for a tabulation of Federal 

direct aid to Puerto Rico in FY 1977 and 1978. 

This Section summarizes U.S. tax rules governing possessions 

corporations. For a fuller discussion of these rules and a 

comparison with the taxation of u.s.-owned branches and subsidiaries in foreign countries, see the Second Annual Repo~' 

pp. 8-23. 

The inability to join a consolidated return means that a loss 

incurred by a 936 corporation cannot be offset against the 

income of an affiliated domestic corporation. 

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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 

Qualified Possession Source Investment Income (QPSII) , 

which is non-business income derived from the possession 

in which the corporation has its trade or business 10/ 

and which is attributable to the investment of funas 

C:rerived from such trade or business. 

The section 936 credit is not available for other income earned 

by a possessions corporation. However, the 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. 

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, possessions corporations often accumulated substantial earnings outside the United States in anticipation of a tax-free liquidation. To accelerate the repatriation 

of earnings, Congress in 1976 allowed U.S. parent corporations to 

claim a dividends-received deduction for dividends from a 936 

corporation. If the 936 is a wholly owned subsidiary (as most 

are), the deduction equals 100 percent of such income, 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 "tollgate" taxes imposed by Puerto Rico on 

such dividends (see below) • 

.!.QI The requirement that QPSII 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. 
-12-

III. Puerto Rican Tax Provisions 

A. Historical Background 

The modern history of ind us trial 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 

pr iv ate enterprise. Tax exemption became the keystone of an 

industrial incentive program that also included providing plants 

at low rent, cash grants to cover start-up costs, and low 

interest loans. 

The Industrial Tax Exemption Act of 1948 offered qualified 

firms an exemption from income, property and municipal taxes. 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. Qualified firms 

also included hotels. In other legislation enacted in 1948, 

Puerto Rico exempted from excise tax all raw materials, 

machinery, and equipment used in manufacturing for export or sold 

to other manufacturers in Puerto Rico. 

In the early 1950's 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 exemption 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 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-year 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 
-13-

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 1969, 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 a 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 936 corporations to 

reinvest a larger portion of their earnings in the Commonwealth, 

Puerto Rico added section 2(j) to the exemption laws of 1954 and 

1963, providing an exemption for interest, rents and dividends 

earned on funds derived from tax-exempt businesses 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. 

Until 1976, dividends distributed by an exempt company to a 

P~rent outside of Puerto Rico were subject to a "tollgate" (or 

W1 thholding) tax, provided that the parent was able to claim a 

~oreign tax credit for the tax. But since such dividends would 

ave been fully subject to U .s. income tax under pre-1976 law, 

Whereas a liquidating distribution was free of both U.S. and 

Puerto Rican tax, 931 companies did not ordinarily pay dividends, 

ana the existence of the Puerto Rican tollgate tax was of largely 

academic interest. In 1976, as noted above, Congress allowed 

U.s. parent companies a dividends-received deduction, but denied 

a foreign tax credit for Puerto Rican or other taxes imposed on 

ihe ~ividend. Under pre-1976 Puerto Rican law, the denial of the 

0 re1gn tax credit would have exempted the dividend from the ~Ollgate tax. However, Puerto Rico at this time eliminated the 

Xemption from the tollgate tax for dividends paid to "nonresi-
-14-

dent" U.S. corporations. 11/ Thus, the tax-free repatriation of 

dividends which possessions corporation expected to be able to 

make after 1976 did not take place. 

B. Present System 

In 1977, the Governor of Puerto Rico appointed a commission 

to study the ind us trial tax exemption program. Out of that 

comm is s ion ' s w or k came the Indus tr i a 1 Incentive Act of 19 7 8 • 

This Act replaced full tax exemption for new firms with partial 

exemption. It also offered possessions corporations the option 

to repatriate earnings at the regular tollgate tax rate of 10 

percent or at significantly lower rates if specified portions of 

earnings were reinvested in designated local investments. This 

new law did not change former tax exemption commitments, but it 

did provide incentives to firms operating under "old" full tax 

exemption commitments to "convert" to partial tax exemption under 

the new Act. This Section discusses, in turn, Puerto Rican 

taxation of non-exempt corporations, taxation under an old exemption contract, taxation under a "converted" exemption contract, 

and taxation under a new exemption contract. 

1. Taxation of Non-Exempt Corporations 

Al though 936 manufacturing corporations operating in Puerto 

Rico normally hold an exemption contract, nonmanufactur in9 

corporations generally do not qualify for an exemption. 

Puerto Rico's authority to enact its own tax system derives 

from the Foraker Act of 1900. In 1954, the legislature adopted 

its present Internal Revenue laws 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. Internal Revenue 

Code. However, the Puerto Rican code contains a "flexible 

.!._!/ 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 nonresidents. 
-15-

depreciation" prov1s1on which permits taxpayers to recover the 

cost of "qualifying property" in any taxable year or years chosen 

by the taxpayer, up to a 1 imi t of 50 percent of total income, 

without regard to the useful life of the property. Generally, 

property acquired for use in agriculture, construction, 

manufacturing, hotels, or shipping qualifies for flexible 

depreciation. 

Dividends paid by a 936 corporation are taxable to a U.S. 

parent corporation if paid out of Puerto Rican source earnings 

and profits. If a 936 has both Puerto Rican and non-Puerto Rican 

source earnings to distribute, the dividend will be considered to 

consist of 50 percent foreign source income and, thus, the effective rate of tax will be half as large as the rate applicable to 

a dividend paid entirely from Puerto Rican source earnings. 

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 dorporation 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 parent 

corporation is not "resident" in Puerto Rico, the dividend is 

subject to a 25 percent "tollgate" tax withheld at source. 

Upon liquidation, a 29 percent tollgate tax applies to Puerto 

Rican source income earned by a non-exempt business. 

2. Taxation Under an Old Exemption Grant 

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

1963 Industrial Incentive Act is 100 percent exempt 12/ from tax 

on business income and interest income on certain designated 

assets (see below). The firm is also 100 percent exempt from 

Property and municipal license taxes. The duration of the tax 

~xemption grant, which depends on the municipality of Puerto Rico 

in which the firm locates its plant, ranges from 10 to 30 years. 

~/ As of April 1980, approximately 210 corporations -- not all 

of them 936's -- enjoyed partial tax exemption under the 1963 

Act. These represented about 10 percent of all grants still 

in effect under that Act. 
-16-

Dividends paid by exempt firms from Puerto Rican source 

Industrial Development Income 13/ to nonresident U.S. parent corporations are subject to Tfie 10 percent tollgate tax. 

However, a tax-exempt firm may benefit from reduced rates if it 

meets certain investment and disbursement conditions. - These 

conditions and rules, summarized below, apply not only to firms 

with old exemption grants, but also to firms with "converted" or 

new exemption grants: 

Dividends paid out of accumulated Puerto Rican source 

Industrial Development Income earned prior to 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 the 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 subsequent to October 1, 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 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. 

g; Industrial Development Income (IDI) is the net income earned 

by an exempt business from the operations declared exempted, 

and the eligible rents, dividends and interests earned by thd 

investment of IDI in Certain Puerto Rico assets (designate 

in section 2(j) of the Industrial Incentive Acts. 
t. 

r 

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3. Taxation Under an Old Exemption Grant "Converted" to 

the 1978 Industrial Incentive Act 

The 1978 Industrial Incentive 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 remaining until the end of 

the 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: 

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 xears 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. Qur ing 

the first five of those ten years, 50 percent of income will 

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 aply for a ten-year extension when the current grant 

expires, but the extension is not automatic. 
-18-

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 is distributed in a given year. 

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 50 percent of such income is 

invested for five years in the firm's own capital assets 

14/ or in assets designated in section 2(j) of the 1978 

Industrial Incentive Act. The designated assets, 

commonly referred to 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 the Puerto Rican Housing Bank 

and Finance Agency, and fixed-term deposits in certain 

banks doing business in Puerto Rico. Banks receiving 

these tax-exempt deposits are in turn required to 

reinvest the funds within Puerto Rico, although thiS 

requirement was not strictly enforced until 1980. l2_/ 

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

are exempt from tollgate tax. 

4. Taxation Under a New Exemption Grant 

New grants issued under the 1978 Industrial Incentive Act 

provide 90 percent exemption from income and property tax in the 

14/ 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 Incentive Act of 1978, 

section 4 ( h) ( 1) ) • 

.!.2,/ Puerto Rican regulations in effect through March 31, 1980' 

permitted banks to "warehouse" 936 deposits outside Puerto 

Rico for up to six months. 

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first five years of a firm's operation, and a 

decreasing rate of exemption during each subsequent 

period until the expiration of the grant, as follows: 

gradually 

five-year 

Years of 

Exemption 

1-5 

6-10 

11-15 

16-20 

21-25 

Percentage of 

Exemption from Income 

and Property Tax 

90% 

75 

65 

55 

50 

Effective Tax Rate on 

Income Derived from 

Manufacturin2 16/ 

Minimum : Maximum 

2.20% 4.50% 

5.50 11.25 

8.75 15.75 

9.90 20.25 

11.00 22.50 

The duration of a firm's grant will vary from 10 to 25 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 

Inanufactur ing 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 

~uerto Rican 2{j) assets, then the dividends, interest, and rents 

erived from those assets will be 100 percent exempt from income 

tax. The intent of this exemption of 2 {j) earnings from income 

tax is to induce 936 corporations to reinvest their business ~arnings in Puerto Rico. However, the main incentive to a firm 

0 retain its earnings in the Commonwealth arises from the i0 llgate tax provisions of the new Industrial Incentive Act, as 

Ollows: 

.!.§.; The minimum and maximum tax rates during a given five-year 

period are computed on the basis of the statutory tax rates, 

which vary from 22 percent to 45 percent depending on the 

firm's income. 
-20-

Dividends paid out of income earned by an exempted 

business are subject to a tollgate tax of 5 percent, 

provided that 50 percent of such income is invested for 

five years in 2(j) assets or in the firm's own capital 

assets. To benefit from the reduced rate, the dis tr ibution must take place before June 30, 1980. The 50 

percent of income reinvested during this period c;an 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. 
CHAPTER 3 

ECONOMIC DEVELOPMENT IN PUERTO RICO 

I. Growth Since 1947 

To put the economic activities of possessions corporations in 

proper perspective, this Chapter provides a brief overview of the 

development of the Puerto Rican economy. Between 1947 and 1972, 

Puerto Rican gross national product and GNP per capita grew at 

the rates of 6 percent and 5 percent per annum, respectively --

see Figure I. 1/ The Puerto Rican economy was badly battered by 

the sudden increase in oil pr ices, the jump in interest rates 

(particularly significant for the construction industry) and the 

1973-75 recession of the U.S. economy. The Puerto -Rican economy 

remained in recession until 1977, but has recovered substantially 

in the last two years with real GNP growing at an annual rate of 

roughly 5 percent in both years. 

II. Industry Composition of Employment 

Despite this rapid growth, unemployment has been a major 

structural problem of the Puerto Rican economy. Unemployment 

gradually declined to 10 percent of the labor force in 1970, rose 

sharply to almost 20 percent in 1977, and though it has declined 

Slightly since then, was still at 17 percent in 1979. 

Table 2 shows the extent to which the rapid growth in GNP has 

been accompanied by a shift in Puerto Rican employment from 

agriculture to manufacturing, particularly in the 1950's and 

1960 's. Employment in manufacturing grew at an average rate of 

4 · 5 percent per annum over these two decades. By 1970, 

rnanufactur ing had displaced both agriculture and wholesale and 

retail trade as the largest sector in terms of employment. The ~apid growth of the manufacturing sector reflected the large 

increase in US investment -- drawn to Puerto Rico by the tax-

~xemption program and low-cost labor -- and the expanding market 

0 r Puerto Rican products provided by the United States. 

However, in the 1970's employment in manufacturing grew at a 

Slower average rate per annum of 1.9 percent and was displaced by 

9overnment as the leading sector in terms of employment. The 160,000 employees in manufacturing in 1979 represented approxiiately a fifth of total employment and a sixth of the total work 

0 rce. In comparison, employees in public administration 

tepresented a fourth of total employment. 

------------ 1; 

- Throughout this chapter unless otherwise noted, years are 

Puerto Rican fiscal years; e.g. 1972 means the twelve months 

ending June 30, 1972. 
,, 

1: 

I 

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-22-

FIGURE I 

Total and Per Capita Gross National Product of Puerto Rico, 

1947-1979 (Constant 1974 Dollars) 

$Millions 

7,000 

6,000 

5,000 

4,000 

3,000 

2,000 

1,000 

'79 

0 

Dollars 

2,400 

2,200 

2,000 

1,aoo 

.1,600 

1,400 

1,200 

1,000 

aoo 

600 

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

Source: Puerto Rico Planning Board 
0 

0 

Table 2 

Puerto Rican Unenployment Rate and Distribution of Enployment in Selected Years, 1950 - 1979 

(in thousands) 

Unenploy- Total Total Agricul- Manufac- Home Wholesale Finance Transporta- Construe- Year ment Enploy- Private Needle- and Retail Insurance tion and Services :Government ture turing ti on Rate ment E~loyment work trade Real Estate Utilities 

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

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

1960 13 .1 543 481 124 81 10 45 97 6 39 75 62 

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

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

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

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

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

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

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

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

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

1978 18.l 780 600 40 156 * 44 149 21 49 138 180 

1979 17.0 807 618 38 160 * 48 154 21 50 142 189 

Annual rate of growth, 

1950 -1960 -1.0% -1.3% -5.3% 3 . 9% -15 . 0% 5.2i 0.8% 7.2% 3.4% -0.3% 3.3% 

Annual rate of growth, 

1960 - 1970 2.4 1.9 -5.0 5.0 5.4 2.0 0.0 1.4 4.5 5.5 

Annual rate of growth, 

1970 - 1979 1.6 0.1 -5.7 1.9 -4.5 1.9 4.9 1.1 2.0 6.o 

Off ice of the Secretary 

Office of Tax Analysis 

y Includes only public administration. 

* Less than 2,000 

n.a. not available 

Sources: Puerto Rico Planning Board, Economic Report to the Governor, 1978 - 1979; Puerto Rico Development Administration, Economic Analysis of the 

Industrial Incentive Program of Puerto Rico, 1978; Institute of ~nternational Law and Economic Development, Puerto Rico Industrial Sector 

Study, Draft Report for the u.s. Department of Commerce, April 1978. 

y 

I 

N 

(.;.) 

I 
-24-

The growth in government employment was made possible in part 

by the large increase in Federal aid. As shown in Figure II, 

Federal taxes covered over 2/ plus grants-in-aid to the Puerto 

Rican Commonwealth and municipal governments increased from $115 

million in 1960 to $1,130 million in 1979 (in constant 1974 

dollars) . Between 1970 and 1979 alone, Federal assistance grew 

from 26 percent to 36 percent of Puerto Rican government 

expenditures plus net investment by public enterprises. ll 

Within manufacturing, the industry composition of employment 

has also been shifting notably. In the 1950's and 1960's, 

employment in labor-intensive industries -- apparel, textiles, 

food-processing and leather goods (including footwear) grew 

rapidly. As shown in Table 3, however, employment in tobacco 

products, textiles, apparel and leather goods declined substantially after 1968. Their decline was, in turn, offset by 

rapid gains in employment in high-technology industries: chemicals, including pharmaceuticals, machinery, transportation equipment, electrical and electronic equipment and scientific instruments. Taken together, these five high-technology industries 

employed 53,800 workers in 1979, which was roughly one third of 

total manufacturing employment and just under 7 percent of total 

employment in Puerto Rico. 

III. Underlying Factors 

What accounts for these structural shifts in the industrY 

composition of Puerto Rican employment? They reflect in part the 

improved education and training of Puerto Rico's labor force. 

But the persistence of high unemployment, together with the 

decline of industries where labor is the major cost of production, suggest that Puerto Rico's labor costs may have been 

increasing more rapidly than those of competitive locations. 

Table 4 present the U.S. minimum wage and average hour lY 

wages in manufacturing in Puerto Rico and the United States 

between 1950 and 1979. It shows that the annual rate of growth 

of average wages in Puerto Rico has exceeded the growth rate id 

the United States in every decade since 1950. This tren 

reflects not only the changing composition of employment in 

Puerto Rico towards higher wage industries, but also the impact 

of Federal minimum wage and income maintenance laws on Puerto 

Includes the Federal excise tax on alcoholic beverages 

produced in Puerto Rico but transported to the United States· 

The sources of this growth between 1968 and 1979 are shown in 

Table 5, below. 

1$Milli 

4,000 

3,500 

3,QQ(J 

2,5()( 

2,0Q 

1,5 

1, 
~t 

. ' 

:o 

.5 

' 4 

:w 

t 

t 

w 

0 

y 

s 

.. 

-25-

FIGURE II 

Distribution of Puerto Rico Government Expenditures 

by Revenue Source, 1960-1979 

(Constant 1974 Dollars) 

$Millions 

4,000 

3,500 

3,0Qo 

2,5()0 

2,00Q 

1.500 

1.000 

50() 

1 

oo ----!--~~~ -----------------

,, 

--- _____ , 

Total Government Expenditures 

plus Net Investment of 

Public Enterprises 

Own Source Revenue 

plus Borrowing 

,, ---t -- ,, I 

Federal 

Grants-In-Aid 

t Federal Taxes Covered Over 

--

61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 
Table 3 

Distribution of Euployment in Puerto Rican Manufactures, 1968 - 1979* 

Industry Group 

All Manufacturing Industries 

Nondurable goods 

Food and kindred products 

Tobacco products 

Textile mill products 

Apparel 

Paper and allied products; 

printing and publishing 

Chemicals 

Pharmaceuticals 

Petroleum refining; rubber 

products; plastics 

Leather and leather products 

Durable goods 

Lumber and wood products; 

furniture and fixtures 

Stone, clay and glass 

products 

Primary metal products; 

fabricated metal products 

Machinery, except electrical; 

transporation equipment 

Electrical and electronic 

equipment 

Scientific instruments 

Miscellaneous manufacturing 

industries 

1968 

137.1 

101.7 

20.5 

7.0 

s.2 

40.2 

6.2 

11.4 

5.0 

2.0 

9.1 

3.8 

3.9 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

1969 

138.5 

loo.a 

20.9 

6.0 

a.1 

40.5 

3.s 

5.o 

1.8 

1.8 

10.5 

4.1 

1970 

136.7 

96.5 

20.6 

6.1 

a.9 

36.8 

1.0 

a.3 

40.2 

5.1 

6.8 

10.7 

5.2 

1971 

138.l 

21.7 

5.6 

6.8 

36.2 

4.1 

7.0 

3.0 

43.6 

5.1 

7.3 

11.8 

1.2 

3.8 

1972 

147.2 

102.5 

23.5 

5.6 

7.7 

39.2 

1.0 

6.1 

5.0 

7.5 

6.9 

1.9 

1973 : 1974 : 1975 

(in thousands) 

152.9 

105.1 

22.7 

5.6 

7.6 

40.7 

4.5 

11.0 

5.o 

6.5 

6.7 

47.8 

4.9 

1.9 

14.8 

9.1 

3.2 

149.6 

102.9 

23.7 

5.3 

7.2 

38.0 

3.8 

12.5 

9.5 

136.6 

93.9 

23.0 

5.0 

4.9 

36.l 

3.s 

10.6 

6.0 

42.8 

3.9 

5.6 

3.5 

9.9 

lo .a 

1976 

144.8 

98.3 

24.2 

4.5 

4.3 

37.1 

4.4 

12.5 

7.3 

6.4 

5.0 

46.4 

3.7 

5.3 

13.3 

10.6 

3.0 

Source: Commonwealth of Puerto Rico, Department of Labor, Census of Manufacturing Industries of Puerto Rico, 

March 1978 and January 1980. 

* Data as of October of each year 

1977 

148.6 

100 .6 

23.9 

3.2 

4.9 

37.2 

4.4 

15.4 

8.4 

1.0 

5.1 

47.9 

5.1 

5.5 

5.3 

1978 

155.9 

102 .2 

24.8 

2.s 

5.1 

36.2 

4.5 

15.9 

9.8 

53.7 

3.9 

5.5 

6.0 

5.9 

16.2 

12.5 

3.8 

1979 

157.7 

100.4 

4.8 

16.3 

10.0 

7.1 

6.0 

57.3 

5.5 

6.0 

6.6 

17.3 

13.6 

Absolute 

Change 

1968-1979 

20,600 

-1,300 

3,800 

-4,800 

-3,900 

-4,800 

1,000 

11,800 

8,600 

900 

-5,400 

21,900 

-800 

-1,200 

1,000 

4,600 

8,200 

9,800 

300 

Percentage 

Change 

1968-1979 

15% 

-1 

19 

-69 

-48 

-11 

26 

262 

614 

15 

-47 

62 

-16 

-17 

20 

230 

90 

258 

8 

I 

N 

°' I 
-27-

TABLE 4 

u.s. Minimum Wage, and Average Hourly Wage Rate 

in Manufacturing in Puerto Rico and the United States 

Average Hourly Wage 

United States: Rate in Manufacturing 

Year Minimum Wage :Puerto Rico 1/:United States 

1950 $0.75 $0.44 

1955 0.15 0.54 

1960 1.00 o.92 

1965 1.25 1.24 

1970 1.60 1.78 

197 1 1.60 1 • 91 

1972 1.60 2.04 

1973 1.60 2 .17 

1974 2.00 2.40 

1975 2 .10 2.59 

1976 2.30 2.86 

1977 2.30 3 .11 

1978 2.65 3.44 

1979 2.90 3.75 

~NNUAL RATE OF GROWTH 

195 0 -1960 7.7% 

1960-1970 6.8 

1970-1979 

Off ice of the Secretary 

Off ice of Tax Analysis 

11 October of each year 

~/ Average for each calendar year 

11 January to May 

$1 .44 

1. 86 

2.26 

2.61 

3.35 

3.57 

3.91 

4.07 

4.41 

4.83 

5. 19 

5.68 

6 .17 

6.54 

4.0 

6.9 

:Puerto Rican Wage 

as a Percentage 

2/: of u.s. Wage 

31% 

29 

41 

48 

53 

54 

54 

53 

54 

54 

55 

55 

56 

~/ 57 

Sources: u.s. Bureau of Labor Statistics, Employment and Earnings; and 

Puerto Rico Department of Labor, Census of Manufactures 
-28-

Rico. After an initial attempt to enforce the 1938 Fair Labor 

Standards Act in Puerto Rico imposed widespread dislocation and 

unemployment, Congress authorized the U.S. Department of Labor to 

establish minimum wages for Puerto Rico which were below the 

mainland level. Under procedures provided by law, the Department 

of Labor appointed committees drawn from industry, labor, and the 

public and representing both the United States and Puerto Rico to 

hold hearings and recommend for individual- ind us tries " •.• the 

highest minimum wage rate ... which (1) will not substantially 

curtail employment. in such classification and (2) will not give a 

competitive advantage to any group in the industry" over mainland 

sectors of the industry. 4/ In contrast to the single minimum 

wage prevailing in the United States, Puerto Rico thus came to 

have industry-specific minimums which served to keep pressure on 

relatively high-wage as well as low-wage industries. As shown in 

Table 4, the annual rate of growth of average hourly earnings in 

Puerto Rico has exceeded the growth rate of U.S. average earnings 

in every decade since 1950. By the end of 1977, almost twothirds of non-government employees in Puerto Rico were subject to 

the U.S. minimum wage. Virtually full application of the U. S · minimum wage to Puerto Rico is to be achieved by 1981. 

A second factor which may have increased the real cost of 

labor in Puerto Rico has been the expansion of Federal income 

maintenance programs in Puerto Rico. 5/ Such programs may reduce 

work incentives and raise labor-training costs by inducing higher 

labor turnover rates. Table 5 provides a breakdown of Federal 

transfer payments in 1968, 1978, and 1979 by major category. Net 

Federal transfers to individuals increased from $68 million ill 

1968 to over $1. 5 billion in 1979, a eleven-fold increase ill 

price-deflated dollars. The growth in income maintenance 

programs was led by the food stamp program, which was n?t 

introduced in Puerto Rico until 1975, but reached $734 million lo 

1979. 

At the same time as the real cost of labor in Puerto Rico was 

being pushed relatively closer to the mainland level and farther 

away from the level in developing countries, structural chang7s 

in the world economy were further undercutting Puerto Rico s 

position as a low-wage site for U.S. investment. After the 

Kennedy round of tariff negotiations in the 1960 's, the United 

!/ Fair Labor Standards Act of 1938, as amended by the 

Congressional Act 76tl1 of June 26, 1940 (Pub. Res. No. 88, 

Congress) • 

Puerto Rico participates in most, but not all, Federal incom: 

maintenance programs. It does not participate in the supple0 mentai Security Income Program and, in the case of Aid \ 1 Families with Dependent Children, payments are limited bY 

ceiling. 

Ne 

Fe 

F 
•or 

.nd 

to 

he 

nt 

he 

to 

he 

ly 

a 

nd 

um 

to 

)n 

in 

in 

}S 

,_ 

:o 

. 

> • 

f 

e 

-29-

Table 5 

Federal Transfer Payments, Grants, and Taxes "Covered Over" 

to Puerto Rico, Fiscal Years 1968, 1978, and 1979 11 

(millions of dollars) 

Net Federal transfer payments to individuals, total 

Food stamps 

Old age, survivors, and disability insurance 

Veterans benefits 

Unemployment compensation 

All other 

Federal grants to Puerto Rican Commonwealth and 

municipal governments, total 

Child nutrition and special milk programs 

Human development ~/ 

Off ice of Education programs 

Public assistance 

Community development block grants 

Low rent public housing 

Employment and training programs 

All other 

y 

FY 1968 

68 

1 

59 

7 

129 

5 

6 

31 

15 

11 

7 

54 

FY 1978 

1,321 

682 

326 

198 

33 

82 

885 

62 

36 

62 

38 

56 

56 

246 

329 

FY 1979 

1,482 

734 

421 

202 

21 

104 

1,020 

77 

64 

69 

114 

74 

56 

262 

304 

e Federal taxes "covered over" to Puerto Rican 

r treasury, total 

1 Customs duties 

t Alcoholic beverage and tobacco excises 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

93 

27 

66 

TOTAL 290 

271 289 

71 76 

200 213 

2,477 2,791 

Sources: u.s. Department of the Treasury, Federal Aid to States: Fiscal Year 1979, and the 

Statistical Appendix to the Secretary's Annual Report for 1968; and Puerto Rico 

Planning Board, Economic Report to the Governor (various years). 

11 In 1968 both the Federal and Puerto Rican fiscal years ended on June 30, and therefore 

all data for FY 1968 is based on the same time period. In 1976, however, the Federal 

fiscal year was changed, beginning on October 1, 1976 and ending on September 30, 

while the Puerto Rican fiscal year again ended on June 30. With the exception of 

certain Federal transfer payments, all data for 1979 are based on the Federal fiscal 

year. 

~/ All transfer payments are net of associated payments by or on behalf of current or 

future recipients, such as employer, employee, and self-employment contributions for 

OASDI. 

1f F ormerly, "child" development. 
-30-

States cut its tariff rates by 40-50 percent on average. As 

Japanese and other competitors utilizing low-wage foreign labor 

penetrated the U.S. market, U.S. companies lost their inhibitions 

about manufacturing in low-wage countries and exporting back to 

the United States. Such countries' exports are subject to U.S. 

tariffs and non-tariff trade barriers, and production in such 

countries does not benefit from the tax exemption provided to 

U.S. companies under the possessions corpora,tion system. But 

these disadvantages may, in labor-intensive industries, be more 

than offset by the low cost of foreign labor. 

The rapid grow th of employment in the high-technology 

industries chemicals, machinery, transportation equipment, 

electrical and electronic equipment, and scientific instruments 

is, as the next Chapter shows, attributable to increasing 

investment in these industries by U.S. corporations. AS 

explained more fully below, companies in these ind us tries are 

typically willing to pay wages substantially higher than the 

Federally mandated minimum. They are attracted to Puerto Rico 

not by the low cost of labor, but by the low tax on profits. 

The difference between the expanding and declining industries 

within the Puerto Rican manufacturing sector is highlighted in 

Table 6, which is based on employment, payroll and value-added 

statistics for 1972 and 1977, the two most recent years in which 

a census of manufactures was conducted in Puerto Rico. ThiS 

period coincided roughly with the recession, which accounts for 

the lower than average growth rates of employment, payroll, and 

value-added. The Table illustrates the impact which the shift in 

industry composition had on labor's share in total value-added. 

The last thr~e rows of the Table show that industries with 

expanding employment were those whose payroll represents the 

lowest percentage of Puerto Rican value-added, and that the 

payroll/value-added percentage decreased between 1972 and 1977· 

By con tr as t, ind us tries with declining employment had high 

payroll/value-added percentages, and those percentages increased 

slightly between 1972 and 1977. Largely because of the change in 

industry composition, manufacturing employment declined slightlY 

between 1972 and 1977, while manufacturing payroll increased bY 

60 percent, and manufacturing value-added (which includes profit) increased by 130 percent. 
Table 6 

Employment, Payroll and Value Added of Puerto Rican Manufacturing Industries, 1972 and 1977 

1972 1977 

:Payroll as :Payroll as 

:Employment: Payroll :Value Added:Percent of :Employment: Payroll :Value Added:Percent of 

{000) : {$ Million):($ Million) :Value Added: (000) : ($ Million):{$ Million) :Value Added: 

All Manufacturing Industries 

Food and kindred products 

Tobacco products 

Textile mill products 

Apparel and other textile 

products 

Lumber and wood products 

Furniture and fixtures 

Paper and allied products 

Printing and publishing 

Chemical and allied products 

Petroleum and coal products 

Rubber and miscellaneous 

plastics products 

Leather and leather products 

Stone, clay and glass products 

Primary metal industries 

Fabricated metal products 

Machinery, except electrical 

Electric and electronic 

equipment 

Transportation equipment 

Instruments and related 

products 

Miscellaneous manufacturing 

industries 

Industries with expanding 

employment .. !/ 

Industries with declining 

employment ~/ 

Industries with constant 

employment ~/ 

149.7 

27.7 

4.5 

7.8 

39.6 

1.2 

3.2 

1.6 

3.0 

9.0 

2.2 

3.5 

6.6 

6.3 

1.0 

5.2 

2.2 

14. 7 

.7 

3.7 

33.3 

102.9 

13.6 

Office of the Secretary of the Treasury 

Off ice of Tax Analysis 

616.8 

121.2 

16.0 

27.9 

124.1 

4.5 

13.0 

0.2 

16.7 

58.8 

20.7 

14.0 

20.4 

29.0 

5.3 

27.6 

12.0 

50.4 

3.1 

29.0 

14.1 

165.1 

390 .o 

61.7 

1,915.4 

343.4 

46.4 

67.1 

252.5 

8.3 

29.3 

17.9 

41.8 

451.2 

91.7 

27.4 

39.3 

73 .1 

14.3 

78.2 

37.6 

169.6 

6.8 

35.3 

798.6 

944.4 

172 .4 

35.3 

34.5 

41.6 

49.1 

54.2 

44.4 

45.8 

40.0 

13.0 

22.6 

51.1 

51.9 

39.7 

37.1 

35.3 

34.0 

29.7 

45.6 

34.4 

39.9 

20.1 

41.3 

35.8 

146.2 

20.6 

4.6 

5.7 

37.9 

.9 

2.3 

1.3 

3.0 

15.1 

2.4 

6.0 

6.3 

4.9 

1.6 

4.4 

3.9 

15.8 

1 .1 

6.1 

45.9 

86. 7 

13.7 

998.5 

143.3 

24.5 

29.9 

172.4 

3.9 

12.3 

11.0 

28.7 

154.1 

36.8 

44.1 

29.3 

39.3 

12.9 

33.9 

33.0 

114.9 

8.2 

46.9 

18.5 

404.0 

494.6 

100.1 

4,449.1 

495.1 

144.9 

33.1 

299.6 

9.3 

26.7 

24.3 

72.2 

1,885.1 

135.7 

151.4 

57.1 

101.3 

45.7 

89.3 

173.5 

459.3 

29.0 

167.7 

48.8 

2,879.7 

1, 184.6 

384.8 

22.4% 

28.9 

16.9 

90 .3 

57.5 

41.9 

46.1 

48.6 

39.8 

8.2 

27.1 

29.1 

51.3 

38.8 

28.2 

38.0 

19.0 

25.0 

28.3 

28.0 

37.9 

14.0 

41.8 

26.0 

Percentage Change in 

Payroll as Percent 

of Value Added 

1972 - 1977 

-30.4\ 

-18.1 

-51.0 

117. 1 

17.1 

-22.7 

3.8 

6.1 

0.1 

-36.9 

19.9 

-43.1 

-1.2 

-2.3 

-24.0 

7.6 

-44.1 

-15.8 

-37.9 

-18.6 

-5.0 

-32.4 

-27.4 

Source: u.s. Department of Commerce, preliminary figures for the 1977 Economic Census of Outlying Areas, Manufactures, Puerto Rico, and 1972 Economic 

Census of Outlying Areas, Manufactures, Puerto Rico • 

.!/ Includes chemicals, petroleum, rubber products, primary metal industries, machinery, electric and electronic equipment, and transportation 

equipment. 

~/ Includes food products, textiles, apparel, lumber, furniture, paper, leather products, stone and clay and glass products, fabricated metal 

products, and miscellaneous manufacturing industries. 

~/ Includes tobacco products, printing and publishing, and instruments and related products. 

I 

w 

I-' 

I 
CHAPTER 4 

SECTION 936--TAX EXPENDITURE AND IMPACT ON 

PUERTO RICAN BUSINESS OPERATIONS 

I. Tax Expenditure 

A. General Considerations 

The Congressional Budget Act of 1974 requires a listing of 

tax expenditures in the United States budget. The Act defines 

tax expenditures as: 

" .•• those revenue losses attributable to provisions of the 

Federal tax laws which allow a special exclusion, exemption 

or deduction from gross income or which provide a special 

credit, a preferential rate of tax, or a deferral of tax 

liability; ..• " 

Section 936 and other provisions of the possessions corporation 

system of taxation clearly come within this definition of a tax 

expenditure. 

Congress' request that all tax expenditures be listed and 

estimated reflects the recognition that a tax expenditure is an 

alternative to a direct spending program. A 1978 Report of the 

Senate Budget Committee 1/ explains the intent of listing and 

measuring Federal tax expenditures, as follows: 

.!/ 

"The listing of a provision as a tax expenditure in no 

way implies any judgment about its desirability or effectiveness relative to other tax or nontax provisions that provide 

benefits to specific classes of individuals and corporations· 

Rather, the listing of tax expenditures, taken in conjunction 

with the listing of direct spending programs, is intended to 

allow Congress to scrutinize all Federal programs -- both 

non tax and tax -- when it develops its annual budget. OnlY 

if tax expenditures are included will Congressional budget 

decisions take into account the full spectrum of Federal 

programs . 

U.S. Senate Committee on the Budget, Tax Expenditure~: 

Relationships to Spending Programs and Background Material~ 

Individual Provisions. 
-33-

"Because any qualified taxpayer may reduce tax liability 

through use of a tax expenditure, such provisions are comparable to entitlement programs under which benefits are paid to 

all eligible persons. Since tax expenditures are generally 

enacted as permanent legislation, it is important that, as 

entitlement programs, they be given thorough periodic consideration to see whether they are efficiently meeting the 

national needs and goals that were the reasons for their 

initial establishment." 

The Senate Budget Committee notes that, b~cause tax expendiiures are estimated on the assumption that behavior and other 

~ws remain unchanged, estimates are subject to important 

imitations. 

"In calculating the revenue loss from each tax expenditure, 

it is assumed that only the provision in question is deleted 

and that all other aspects of the tax system remain the 

same ••• 

" ••• the amounts shown for the various tax expenditure 

items do not take into account any effects that the removal 

of one or more of the i terns might have on investment and 

consumption patterns or on any other aspects of individual 

taxpayer behavior, general economic activity, or decisions 

regarding other Federal budget outlays or receipts ••• 

"However, these tax expenditure estimating considerations 

are similar to estimating considerations involving entitlement programs. Like tax expenditures, annual budget estimates for each transfer and income security program are computed separately. However, if one program, such as veterans' 

pensions, were either terminated or increased, this would 

affect the level of payments under other programs, such as 

Welfare payments. Also, like tax expenditure estimates_, the 

elimination or curtailment of a spending program, such as 

military spending or unemployment benefits, would have substantial effects on consumption patterns and economic 

activity that would directly affect the levels of other 

spending programs." 

B. Current Estimates 

Po The calculation of the Federal tax expenditure for the 

amssessions corporation system of taxation reflects not only the 

l'\tount of credit claimed under section 936, but other related t' ov . . Una is1ons of Federal income tax. The amount of credit claimed 

er section 936 for tax year 1978 was $1.08 billion; the 
-34-

estimated Federal tax expenditure for the possessions corporation 

provisions for the 1978 tax year was $840 million. 2/ This figure 

was computed by multiplying the qualified possession source 

income of 936 companies (except those in nonmanufacturing 

ind us tries) 3/ by 40 percent, and then subtracting income and 

tollgate taxes paid to Puerto Rico. 4/ The 40 percent figure 

represents the Treasury's necessarily rough estimate of what the 

effective rate of taxation would have been in the absence of the 

possessions corporation provisions. 5/ The effective rate is 

less than 48 percent, the maximum statutory rate in 1978 (and, 

']._/ 

]/ 

ii 

Tax year 1978 includes accounting periods ending between 

July 1, 1978, and June 30, 1979. Because most possessions 

corporations have calendar year accounting periods, the $840 

million Federal tax expenditure for tax year 1978 corresponds 

closely to the $826 million reduction in calendar year 1978 

tax liabilities, shown on Table 1, above. 

It was assumed that 936 companies in nonmanufactur ing 

industries did not qualify for a Puerto Rican tax exemption 

grant and that the taxes which they paid to Puerto Rico offset 100 percent of their U.S. tax liability. While the 

Puerto Rican Industrial Incentive Acts do provide exemptions 

to designated nonmanufactur ing ind us tries -- in particular, 

hotels, medical laboratories, movie production, and, after 

1978, various services produced for export the total 

possession source income of 936' s in these categories was 

negligible in 1978. Moreover, a sample of the 1978 Puerto 

Rican tax returns filed by 936's in nonmanufacturing 

industries suggests that the average effective Puerto Rican 

tax rate for such companies was roughly 40 percent. 

Puerto Rico estimates that in 1978, $5 million in income 

taxes were paid by 936 firms which had converted to partial 

tax exemption. Tollgate tax collections in calendar year 

1978 were estimated to be $57 million, the average of 

collections for the fiscal years ending on June 30, 1978, and 

June 30, 1979. 

See Department of the Treasury, Effective Income Tax Rates 

Paid by United States Corporations in 1972, May 1978. For 

1979 and all subsequent years, the effective Federal corporate tax rate is assumed to be 38 percent, rather than 40 

percent, to reflect the statutory U.S. corporate tax rate 

reduction of two percentage points. 
-35-

thus, the rate which would apply to most income qualifying for 

the section 936 credit), because other provisions of the Internal 

Revenue Code (e.g., the investment tax credit and accelerated 

depreciation) would have reduced the tax burden by an estimated 

eight percentage points. 

Whether the $840 million tax expenditure for the possessions 

corporation system of taxation should be viewed as a Federal or a 

Puerto Rican expenditure (or both) is ambiguous. In the absence 

of the special provisions, Puerto Rico would assert its primary, 

source jurisdiction and the United States its secondary, residence jurisdiction (possessions corporations are chartered in the 

United States). The United States would allow a foreign tax 

credit for income taxes paid to Puerto Rico, and if Puerto Rico 

taxed such income at its normal rates, the residual U.S. tax 

liability would be small, if any. The incentive to invest in 

Puerto Rico arises because both the Puerto Rican and the Federal 

government offer special inqentives; if either repealed or scaled 

back those incentives, the measured tax expenditure would be 

reduced. 

The Puerto Rican tax expenditure on the possessions corporation system of taxation reflects not only its income and tollgate 

tax provisions, but also exemptions granted for property and 

municipal taxes. The value of the Puerto Rican property and 

municipal taxes forgiven to 936 corporations amounted to 

approximately $110 million in 1978. ii 

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

.§.I The $110 mi 11 ion was computed by mu 1 tip 1 y i ng the 3 percent 

effective real property tax rate by the $1,794 million of net 

plant and equipment and land owned by possessions corporations, by multiplying the 4.2 percent personal property tax 

by their $878 million in inventories, and by multiplying the 

0. 3 percent gross receipts tax by their $6, 451 million in 

business receipts. The asset and income figures used were 

taken from the u. s. income tax returns filed for 1978 by 

possessions corporations in manufacturing industries. 
-36-

II. Characteristics of Possessions Corporations 

A. Information from S.E.C. 10-K Reports 

Many parent companies must file 10-K Reports with the U.S. 

Securities and Exchange Commission and these Reports, unlike tax 

returns, are available to the public. To explain why Federal 

income tax payments are less than 48 percent (the maximum statutory Federal tax rate prior to 1979) of pre-tax book income, the 

S.E.C. requires corporations to indicate which provisions of the 

Internal Revenue Code reduced their tax liability by more than 

2.4 percent of pre-tax book income. Information from 10-K 

Reports, presented in Table 7, shows that 29 parent companies 

reported tax savings of $464 million in 1978. The average tax 

savings reported by pharmaceutical parent corporations was $24.7 

million; the average tax savings reported by non-pharmaceutical 

parent companies was $5.2 million. 

In interpreting these figures, three points should be kept in 

mind. First, because the S.E.C has never set forth specific 

procedures for estimating the dollar value of various tax preferences, the data presented in Table 7 should be regarded as only 

rough estimates of the importance to the companies of section 

936. Second, companies for whom the tax savings may be large in 

dollar terms, but less than 2. 4 percent of book income before 

taxes, need not, and generally do not, report , this i tern separately. Third, even when tax savings exceed 2.4 percent of book 

income, companies may combine the tax savings attributable to 

possessions corporations with other items (e.g., deferral or 

DISC) • Companies following this practice were excluded from 

Table 2. 

B. Income Tax Return Information 

Tables 8 through 12, based on actual U.S. income tax returns 

filed for tax year 1978 by possessions corporations, present by 

industry year-end balance sheet figures, income statement data' 

and estimated Federal tax expenditures. The Federal tax 

expenditure estimates are based on all 565 corporations which 

filed as 936 corporations for tax year 1978; the balance sheet 

and income statement figures cover the 534 corporations for which 

balance sheets and income statements were available. 
-37-

Table 7 

Major U.S. Manufacturing Corporations Indicating a Tax Savings 

Under Section 936 on Their SEC 10-K ~eports for 1978 

Corporation Industry 

Tax Savings 

Percent of 

Amount : Book Income 

:($Millions} :(Before Taxes} 

Abbot Labs 

American Hospital 

Supply 

Baxter-Travenol 

Becton-Dickinson 

Eli Lilly 

G.D. Searle 

Johnson & Johnson 

Merck 

Pfizer 

Richardson-Merrell 

Schering-Plough 

Smith-Kline 

Squibb 

Sterling 

Upjohn 

Warner-Lambert 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Pharmaceuticals 

Subtotal - 16 Pharmaceuticals 

$ 24.1 

13.5 

29.3 

5.4 

23.6 

31. 5 

19.6 

25.1 

52.2 

4.7 

54.5 

27.4 

28.0 

3.2 

26.8 

27.1 

$ 395.6 

Allen Group 

Blue Bell 

Conagra 

Automotive $ 16.0 

6.1 

2.4 

Digital Equipment 

Esmark 

Gould 

Hanes 

H. J. Heinz 

Insilco 

Morton-Norwich 

Motorola 

Perkin-Elmer 

Textile/Apparel 

Food Processors 

Off ice Equipment 

Food Processors 

Electronics 

Textile/Apparel 

Food Processors 

Building Materials 

Chemicals 

Electronics 

Instruments 

Subtotal - 13 Non-Pharmaceuticals 

TOTAL - 29 Manufacturers 

Off ice of the Secretary of the Treasury 

0f f ice of Tax Analysis 

17.4 

8.8 

1.8 

3.4 

9.1 

3.4 

3.1 

9.2 

2.0 

$ 68.2 

$ 464.1 

10.6% 

9.6 

24.8 

6.1 

5.1 

29.1 

3.9 

5.1 

17.1 

4.1 

20.3 

10.5 

18.0 

1.8 

13.4 

7.7 

10.0% 

13.0% 

6.5 

7.4 

7.9 

7.4 

1.1 

10.6 

5.1 

9.9 

5.3 

4.3 

3.2 

5.6% 

8.9% 

Source: Taxation with Representation, Tax Notes (recent issues}. 
-38-

Assets. Table 8 shows that the total assets of 936 corporations stood at $12.0 billion at year-end 1978, with 79 percent of 

the assets held by manufacturing companies. Within manufacturing, the pharmaceutical industry accounted for $4.2 billion, 

or 35 percent of the total, and the electrical and electronic 

equipment industry for $1.4 billion, or 12 percent of the total. 

Net plant and equipment of 936 manufacturing firms, (shown as 11 net de pre c i ab 1 e assets 11 on Tab 1 e 8 ) amounted to $1 • 2 bi 11 ion · 

This represented 13 percent of total assets held by all 936 manufacturing firms. If the value of land (not separately shown in 

Table 8) is added to net plant and equipment, the total of these 

real assets as a percentage of total assets is 15.3 percent. For 

U.S. manufacturers as a whole, the comparable figure was 35.l 

percent. 7/ This difference may in part reflect the fact that 

Puerto Rico leases government owned buildings to a substantial 

sector of the industrial community. Table 9 compares, bY 

manufacturing industry, the ratio of real assets to total assets 

for possessions corporations and for all U.S. corporations. ThiS 

ratio for 936 companies was lower in every manufacturing industrY 

than the comparable ratio for all U.S. firms. 

J_/ Data for all U.S. corporations are from the Federal Trade 

Commission, Quarterly Financial Report, Fourth Quarter, 191..!!: 

Some of this difference can be attributed 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 possessions 

corporations in each industry were distributed between reai 

and all other assets in the same manner as were assets of al 

U.S. corporations in that industry. These amounts were the~ 

summed over all industries to get an industry mix correct: 

amount of real assets. Taking the ratio of this industry.ml~ 

corrected amount to total assets of 936 manufacturing f1rm 

gives 28.6 as the percentage of real to total assets. ThUS' 

the differing industry mix between possessions corporation: 

and all U.S. corporations explains one third (35.l 

28.6)/(35.1 - 15.3) of the difference between the types of 

assets held. 
() .... ' H\ ' 

Table 8 

Selected Balance Sheet Information by Industry, 1978 

(Dollar amounts in thousands) 

All Manuf actun~ Industries 

Industries Total Fcxxl & Kindred:Tobacco : Textile f\Warel Paper Chemicals 

Products : Products: Mill Products: Total :Pharmaceuticals:All Other 

Nl.ITlber of corporations 534 390 17 4 5 73 4 81 57 24 

Total assets 12,008,644 9,455,564 726,761 165,690 40,668 273,812 9,336 5,297,745 4,227,396 1,070,349 

Cash 1,696,945 1,633,632 210, 775 4,768 2,840 34,390 4,601 856,665 765,837 90,827 

Accounts receivable 1,979,401 1,644,857 114,282 47,873 16,327 88,191 1,171 832,388 501,497 330,891 

Inventories 1,037,849 901,287 100,839 33,997 4,619 42,243 677 378,779 271,610 107,169 

U.S. Goverrment obligations 232,085 230,940 0 0 0 3,735 0 117,823 271,610 21,967 

State and local obligations 228,980 228,980 0 0 0 501 0 194,517 171,145 23,372 

Other current assets 459,388 435,576 27,605 26,201 589 7,286 14 226,179 218,585 7,593 

Mortgage & real estate loans 1,212,273 133,629 0 0 0 3,075 0 9,182 9,100 82 

Other investments 2,656,407 2,539,635 58,153 31,997 11,250 38,525 487 1,692,669 1,521,293 171,375 I 

w 

Depreciable assets 2,712,886 1,826,490 169,507 26,992 6,149 37,621 2,583 1,088,468 556,797 531,670 'F 

Less: Accunulated depreciation 787,842 604,057 47 ,595 9,650 2,113 15,097 724 355,091 100,516 254,575 

Net depreciable assets 1,925,044 1,222,433 121,912 17,342 4,035 22,524 1,859 733,376 456,281 277,095 

Other assets 580,268 494,591 93,191 3,509 1,005 33,338 525 256,163 216,189 39,974 

Total Liabilities and 

Stockholder's Equit~ 

Accounts Payable 676,982 486,252 61,756 2,452 4,181 30,201 83 199,781 144,882 54,898 

Notes Payable in less than 1 year 207,292 94,150 33,966 0 238 2,109 58 32,520 31,072 1,448 

Other current liabilities 1,489,015 394,498 56,224 8,271 895 7 ,471 346 236,169 222,961 13,208 

Mortgages more than 1 year 525,359 225,999 3,111 0 0 6,029 293 180,028 169,823 10,205 

Other liabilities 198,676 82,754 7,175 781 1,353 477 92 46,746 24,174 22,572 

Capital stock 1,495,811 940,458 59,765 43,014 1,595 22,228 3,096 599,093 369,252 229,840 

Retained earnings, total 7,415,514 7,231,452 504,761 111,169 32,404 205,294 5,365 4,003,404 3,265,229 738,175 

Appropriated 77,644 37,734 0 0 0 3,141 0 2,473 2,265 208 

Unappropriated 7,337,869 7,193,718 504,761 111,169 32,404 202,152 5,365 4,000,930 3,262,963 737,966 

Office of the Secretary 

Office of Tax Analysis 
Table 8 - continued 

Riibber Leather 

Manufacturi!!9 Industries - continued 

ana Stone, Clay, & Fabricated Machinery, Electrical and scientific* 

Products Leather Products Glass Products : Metal Products ExceEt Electrical Electronic Equi~nt Instruments 

Number of corporations 10 8 6 19 13 83 28 

Total assets 68,631 41,300 72,239 168,252 227,177 1,438,525 251,111 

cash 10,747 10,408 14,209 59,078 28,743 322,142 31,468 

Accounts receivable 11,163 9,382 39,095 18,528 63,273 140,715 68,014 

Inventory 7,743 5,942 5,008 22,544 60,419 104,193 26,942 

U.S. Goverrment obligations 0 3,267 0 0 0 96,977 0 

State arrl local obligations 0 5,032 0 0 850 28,077 0 

Other current assets 14,689 915 146 692 3,693 37,795 12,686 

Mortgage & real estate loans 0 0 0 0 31,307 90,064 0 

Other investments 2,491 5,687 2,164 21,492 13,790 532,561 48,594 

Depreciable assets 28,242 1,832 17,002 46,312 39,106 106,263 43,388 I 

Less: Accumulated depreciation 9,081 1,194 7, 713 11,858 15,007 37,077 8,763 ~ 

Net depreciable assets 19,160 638 9,288 34,453 24,098 69,186 34,625 I 

Other assets 2,637 24 2,327 11,461 1,001 16,811 28,780 

Total Liabilities arrl 

Stockholaer 1s Equit~ 

Accounts payable 7,245 1, 773 1,013 25,992 13,336 67,136 11,823 

Notes payable in less than 1 year 187 241 364 962 11,947 2,636 7,703 

Other current liabilities 2,080 519 2,619 1,191 5,018 23,924 11,336 

Mortgages more than 1 year 286 0 20 565 1,551 13,721 7,358 

Other liabilities 22 17 2,005 4,264 1,817 10,852 2,245 

capital stock 11, 713 921 729 6,374 3,109 56,970 33,700 

Retained earnings total 47,096 37,826 65,485 128,901 190,396 1,263,283 176,943 

AH:>ropriated 119 0 0 0 2,641 3,262 0 

Unawropriated 46,977 37,826 65,485 128,901 187,754 1,260,020 176,943 

Off ice of the Secretary 

Office of Tax Analysis 

* Includes photographic goods and watches 
Table 8 - continued 

All other Transportation 

Norunanufacturi!:!S I~ustries 

Finance, Miscellaneous 

Manu- Total Construction Ccmnunications Wholesale Retail Insurance, Services and 

facturi!:!S and Utilities Trade Trade : Real Estate Not Available 

Nllriber of corporations 34 142 10 9 21 54 25 20 3 

Total assets 210,720 2,549,698 19,445 661,794 46,348 202,338 1,561,919 51,458 6,393 

Cash 41,519 63,307 2,723 6,595 1,243 2,578 48,062 1,984 121 

Accounts receivable 63,809 333,261 10,223 30,189 12,462 52,834 207,840 15,350 4,360 

Inventory 29,723 134,679 783 6,674 16,665 52,484 56,188 1,094 788 

U.S. Goverl'Jllent obligations 0 1,145 0 0 0 0 1,144 0 0 

State and local obligations 0 0 0 0 0 0 0 0 0 

Other current assets 1,995 23,811 1,716 4,185 958 6,208 10,024 664 53 

Mortgage & real estate loans 0 1,078,644 0 0 0 0 1,078,644 0 0 

Other investments 30,355 126,772 20 1,399 1,444 11,707 106,613 5,588 0 

Depreciable assets 46,951 886,097 5,203 695,181 17,711 93,056 44,834 29,432 678 

Less: Accunulated depreciation 7,993 183,689 2,255 132,249 5,919 32,488 4,980 5,591 204 I 

Net depreciable assets 38,958 702,407 2,947 562,932 11,792 60,567 39,853 23,841 473 .I>-

t--' 

Other assets 4,359 85,673 1,031 49,817 1,780 15,963 13,547 2,934 596 I 

Total Liabilities and 

Stockfiolaer 1s Equit~ 

Accounts payable 16,455 188,093 3,261 23,843 10,190 37,538 102,195 10,153 909 

Notes payable in less than 1 year 1,213 113,142 689 2,570 1,210 24,028 83,448 805 388 

Other current liabilities 7,015 1,094,389 2,652 21,182 3,073 12,064 1,052,501 2,628 288 

Mortgages more than 1 year 12,915 299,359 1,287 101,425 19,922 25,374 140,032 11,318 0 

Other liabilities 811 115,921 1,939 11,933 1,024 2,168 98,645 203 7 

Capital stock 12,260 554,853 135 496,383 9,269 28,154 15,390 5,324 195 

Retained earnings total 160,048 183,943 9,480 4,455 1,656 73,015 69,704 21,024 4,605 

Appropriated 190 39,791 0 1,212 0 2,962 35,113 502 0 

Unappropriated 159,858 144,151 9,480 3,243 1,656 70,052 34,590 20,522 4,605 

Off ice of the Secretary 

Office of Tax Analysis 
-42-

Table 9 

Possessions Corporations and All U.S. Corporations: 

Net Property, Plant and Equipment as a 

Pecentage of Total Assets, 1978 

Industry 

All Manufacturing Industries 

Food and kindred products 

Tobacco manufactures 

Textile mill products 

Apparel 

Paper and allied products 

Chemicals 

Pharmaceuticals 

All other 

Rubber products 

Leather products 

Stone, clay, glass and concrete products 

Fabricated metal products 

Machinery, except electrical 

Electrical machinery 

Professional and scientific instruments 

Off ice of the Secretary 

Off ice of Tax Analysis 

Possessions 

Corporations 

15.3% 

17.4 

11.3 

10.8 

8.6 

29.6 

17.6 

14.5 

35.8 

28.7 

1.6 

11.8 

21.3 

10.8 

4.7 

15.4 

1/ 

All U.S. 

Corporations 

35.1% 

34.9 

23.4 

31.9 

n.a. 

49.6 

39.4 

24.8 

47.4 

32.6 

n.a. 

43.8 

27.6 

27.5 

23.2 

27.3 

!/ Includes possessions corporations operating in .American Samoa, Guam and 

the Panama Canal Zone. These non-Puerto Rican operations account for less 

than .2 percent of net income of all possessions corporations in 1978. 

Source: Tax return Form 1120 filed by possessions corporations; and Federal 

Trade Conunission, Quarterly Financial Report, Fourth Quarter, 1978. 

n.a. - not available 
-43-

The counterpart to relatively little investment in real 

assets by 936 manufacturing firms is relatively large investment 

in financial assets. 8/ Possessions corporations in manufacturing 

ind us tries reported financial assets of $7. 2 billion, of which 

$1.6 billion represented accounts receivable. Possessions 

corporations in industries other than manufacturing had $1.7 

billion in financial assets. ~/ 

Retained Earnings. The continuing incentive to retain 

earnings in 936 companies is also clearly reflected in the $7.4 

billion of retained earnings they held at year-end 1978. Fortyseven percent of these retained earnings, or $3.5 billion, was 

held by pharmaceuticals. Retained earnings represented 77 percent of total liabilities and stockholders' equity of all 936 

manufacturing corporations. The comparable figure for all U.S. 

manufacturing corporations was 39 percent . .!.Q/ 

Total Receipts. Table 10 shows that total receipts of 

possessions corporations we're $7.8 billion in 1978. Nearly 95 

Percent of total receipts were attributable to business receipts, 

and the remainder were attributable primarily to interest on nongovernment securities. Note that 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 

~eceipts shown in Table 10. The amount of such exempt interest 

income reported by all 936 firms for tax year 1978 was $16 

million. One third of the receipts of all manufacturing 

ind us tries was accounted for by pharmaceuticals. After pharmaceuticals, the ind us tries with the greatest business receipts 

Were electrical and electronic equipment, food products, and 

chemicals other than pharmaceuticals. 

Net Income Per Return. Net income per return (total receipts 

minus total deductions) amounted to $2.4 billion for all possessions corporations, of which over 90 percent was attributable to 

manufacturing. The ind us tries with the greatest amount _ of net 

income were pharmaceuticals, with 50 percent of the total manufacturing income, and electrical and electronic equipment and 

food products, which together accounted for an additional 20 

Percent of net income in manufacturing possessions corporations. 

~/ The incentives for 936 firms to accumulate earnings in Puerto 

Rico are discussed on pages 63 - 64, below. 

~/ The breakdown of these financial assets and their impact on 

real investment in Puerto Rico is the subject of Chapter 5, 

below. 

!QI Using the same procedure described in footnote 7, above, the 

ratio corrected for industry mix is 41 percent. 
Table 10 

Selected Incane Statement Information and Tax Expenditure by Industry, 1978 !I 

(Dollar amounts in thousands) 

All Manufacturing Industries 

Industries Total Food & Kindred:Tobacco : . Textile Apparel Paper Chemicals 

Products :Products:M1ll Products: Total :Pharrnaceuticals:All Other 

Number of corporations 534 390 17 4 5 73 4 81 57 24 

Total recei12ts 7,844,959 6,977 t 771 697,323 191,682 43,553 339,499 8,729 2,967,174 2,251,405 715, 768 

Business receipts 7,330,392 6,645,876 677,152 189,414 33,964 331,197 8,425 2,775,242 2,070,659 704,583 

Nongovernment interest 337,286 232,902 19,528 2,642 153 3,424 148 132,227 121,980 10,247 

Other receipts 177,280 98,991 642 - 374 9,434 4,877 156 59,704 58,766 937 

Total deductions 5,913,619 4,981,862 544,520 166,179 38,439 282,723 6,050 1,980,009 1,167,733 812,276 

Cost of sales 4,290,670 3,736,487 455,346 153,405 28,684 254,622 5,013 1,109,734 662,366 447,367 

All other deductions 1,622,949 1,245,374 89,174 12, 774 9,755 28,100 1,036 870,275 505,366 364,908 1. 

.!>-

Estimated net inccrne per return 2,383,263 2,285,487 152,803 25,502 5,113 56,504 2,679 1,277,014 1,083,522 193,491 I 

Estimated net income per books 2,296,644 2,207,006 140,505 30,993 4,966 57,384 2,842 1,241,903 1,064,538 177,364 

Tax e~nditures !:J 839,342 839,342 50,875 9,545 3,286 22,360 719 465,153 412,286 52,867 

Distributions, total 1,151,079 1,100,830 155,241 3,500 37 45,965 0 581,074 501,221 79,852 

Cash 1,053,792 1,003,543 123,274 3,500 37 45,475 0 517,292 458,734 58,558 

All other 97,287 97,287 31,966 0 0 489 0 63,781 42,487 21,293 

Office of the Secretary 

Office of Tax Analysis 
Table 10 - continued 

Manufacturi 

Rubber Leather and Stone, C ay, & E ectnc :Sc1ent1 ic 

Products Leather Products Glass Products Electronic F.qui~nt Instn.ments 

Nl.ltlber of corporations 10 8 6 19 13 83 28 

Total receiets 55,331 47,800 63,306 122,436 386,855 739,480 194,268 

Business receipts 52,837 47,100 51,615 116,084 377,413 688,260 189,994 

Nongoverl'ltlellt interest 1,014 687 1,887 2,880 9,208 44,906 3,044 

Other receipts 1,478 11 9,803 3,471 233 6,313 1,229 

Total deductions 43,001 39,670 47,218 88,007 243,253 419,262 125,339 

Cost of sales 33,156 35,977 40,156 79,801 205,511 347,484 92,116 All other deductions 9,844 3,693 7,061 8,205 37,742 71,778 33,222 

Estimated net incane ~r return 12,329 8,129 16,087 34,429 143,601 320,218 68,928 

Estimated net incane ~r books 12,171 8,169 14,089 32,206 112,659 320,862 71,675 I 

"' \J1 

I 

Tax e~ndi tures y 4,802 3,206 5,932 17,084 47,720 125,054 26,803 

Distributions, total 1,816 40 0 564 162,398 27,903 7,460 

cash 1,816 40 0 564 161,360 27,903 7,448 

All other 0 0 0 0 1,038 0 12 

Off ice of the Secretary 

Off ice of Tax Analysis 
Table 10 - continued 

Normanufacturi!,!9 Industries 

All other Transportation ·Finance, Miscellaneous 

Manu- Total Construction Coomunications Wholesale Retail Insurance, Services and 

facturi!,!9 and Utilities Trade Trade : Real Estate Not Available 

Nl.lllber of corporations 34 142 10 9 21 54 25 20 3 

Total receiets 228,365 1,028,791 39,973 194,649 107,250 497,317 130,631 51,007 7,961 

Business receipts 225,107 892,461 38,554 189,364 105, 721 484,753 19,655 46,486 7,925 

Nongovernment interest 2,196 104,383 337 402 42 11,145 92,316 130 10 

other receipts 1,062 31,946 1,081 4,882 1,486 1,418 18,659 4,391 25 

Total deductions 165,221 930,984 35,588 143,593 101,755 483,550 116,427 44,172 5,896 

Cost of sales 132,951 554,102 32,378 68,809 74,879 328,841 11,503 33,065 4,624 

All other deductions 32,270 376,881 3,209 74,783 26,875 154,709 104,924 11,106 1,272 I 

Estimated net income per 63,144 97,598 4,384 50,848 5,495 13,766 14,204 6,834 2,064 .!'-return 0\ 

I 

Estimated net incane per books 62,282 89,637 2,586 48,630 5,470 11,419 12,633 6,750 2,147 

Tax expenditures !:f 56,803 0 0 0 0 0 0 0 0 

Distributions, total 6,406 50,248 497 47,688 0 107 1,650 304 0 

Cash 6,406 50,248 497 47,668 0 107 1,650 304 0 

All other 0 0 0 0 0 0 0 0 0 

Off ice of the Secretary 

Office of Tax Analysis 

Includes data for possessions corporations operating in American Samoa, Guam and the Panama Canal Zone. 

percent of the net incane of all possessions corporations in 1978. 

'lllese non-Puerto Rican operations account for 0.2 

!:f Includes an additional 31 tax returns for which qualified possessions source incane was available, but incane 

statement and balance sheet information were not available. 

~ Includes photographic goods and watches. 
-47-

Tax Expenditures. As explained above, the Federal tax expenditures are estimated by applying an assumed 40 percent effective 

U.S. tax rate to the qualified possession source income reported 

by each 936 manufacturing company on its U.S. income tax return, 

and then subtracting income and tollgate taxes paid to Puerto 

Rico. As explained in footnote 2, above, possessions corporations outside of the manufacturing sector were presumed to pay a 

rate of income tax to Puerto Rico of at least 40 percent, and 

thus they do not give rise to any Federal tax expenditure. The 

Pharmaceutical industry accounted for fifty percent of the total 

tax expenditure. An additional 15 percent was accounted for by 

the electrical and electronic equipment industry. 

Distributions. The final line in Table 10 shows that the 534 

Possessions corporations for which balance sheets were available 

reported $1.15 billion of distributions, which was slightly less 

than 50 percent of their net income in tax year 1978. One half 

Of total distributions, or $581 million, were attributable to the 

Pharmaceutical industry. 

C. Payroll and Employment Data 

To gain as complete a picture of 936 companies' operations as 

Possible, information from possessions corporations' U.S. income 

tax returns was matched with payroll and employment data from the 

companies' Federal unemployment insurance tax returns. Tables 11 

and 12 are based on all 936 firms in the manufacturing sector for 

Which 1978 employment and payroll data could be obtained. The 

coverage represents 80 percent of the number of manufacturing 

~ 

~ompanies included in Tables 8 through 10, and the combined ~ 

of the sample -- $1,941 million -- represents 86 percent 

of the net income of all manufacturing possessions corporations. 

For the manufacturing companies covered, the tax expenditure 

ler employee averaged $12, 667, which was 18. 4 percent greater 

han the average employee compensation of $10,697. Using figures 

~hown in Table 11, Figure III illustrates how the Federal tax 

t~Penditure per employee varied from one industry to another. In 

e e chemical industry, the tax expenditure was $38,446 per 

t~Ployee, or more than two and a half times the average compensae 10 n of the comparatively well paid Puerto Rican chemical 

imPloyee. By contrast, in the food, textile and apparel 

~dustries, the tax expenditure per employee was $3,016, a third 

a the average wage. Figure III shows that the chemical industry 

c ccounted for 57 percent of the total Federal tax expenditure, 

a~mpared to 20 percent of the total employment. The food, textile 

Ped apparel industries, on the other hand, accounted for only 8 

p rcent of the total Federal tax expenditure but provided 34 

ercent of the total employment. 
Table 11 

Tax Expemiture, Employment am Cmlpensation of Employees by In:lustry, 1978 

:Qualified : Canpensation :Tax Expemiture: Avera}e 

::Ebssession: Tax E~nditure Emplo:t:ees of ~lo:t:ees 21... Tax Expemiture:as a Percent of: Employee 

Nunber of :Net Incane: .Amomt :Percent of :Percent of .Amolnt :Percent of Per Employee Canpensation : Canpensation 

:Coq~~rations: ($000)11...: ($000) : Total Number Total ($000) : Total ($) of Emplo:t:ees ($) 

All Manufactur i03 Imustries 301 1,941,130 726,907 100.0 54,306 100.0 586,864 100.0 12,667 y 118.4 y 10,697 y 

Food and kimred 13 102,793 36,591 5.0 6,787 12.5 69,656 11.9 5,391 52.5 10,263 

Meat am dairy 3 11,159 2,762 * 2,688 4.9 26,094 4.4 1,027 10.5 9, 707 

All other 10 91,634 33,829 4.7 4,099 7.5 43,562 7.4 8,252 77.6 10,627 

Tobacco manufactures 3 20,043 7,781 1.1 931 1. 7 9,977 1. 7 8,357 77.9 10, 716 

Textile mill products 3 3,185 1,263 * 522 1.0 5,064 1.0 2,419 24.9 9,701 

Apparel 60 50,407 18,304 2.5 11,312 20.8 89,284 15.2 1,618 20.5 7,892 

Men's and boy's 13 10,278 2,662 * 2,589 4.8 20,476 3.5 1,028 13.0 7,908 I 

Wcrnen's and children's 25 17,379 6,663 0.9 4,123 7.6 32,102 5.5 1,616 20.7 7,786 .!>-

00 

Hats, caps, etc. 7 2,488 982 * 1,303 2.4 10,620 1.8 753 9.2 8,150 I 

All other 15 20,262 7,997 1.1 3,297 6.1 26,086 4.4 2,425 30.6 7,912 

Paper 3 1,069 425 * 99 * 1,113 * 4,292 38.1 11,242 

Chenicals 59 l,096,256 413,027 56.8 10,743 19.8 154,502 26.3 38,446 267.3 14,381 

Industrial chemicals, 

plastics 7 88,453 34,935 4.8 1,591 2.9 31,903 5.4 21,957 109.5 20,052 

Phaonaceuticals 42 968,090 363,178 50.0 8,395 15.4 114,328 19.5 43,261 317.6 13,618 

Soaps, cleaners, etc. 3 13,257 5,130 0.7 431 0.8 4,288 0.7 11,902 119.6 9,948 

All other 7 26,456 9, 784 1.3 326 1.0 3,983 0.7 30,012 245.6 12,217 

Rubber 8 6,099 2,324 * 689 1.3 6,492 1.1 3,373 35.7 9,422 

Leather 7 7,541 2,994 * 1,098 2.0 8,663 1.5 2, 726 34.5 7,889 

Footwear 4 4,946 1,963 * 773 1.4 5,920 1.0 2,539 33.1 7,658 

All other 3 2,595 1,031 * 325 0.6 2, 743 0.5 3,172 37.5 8,440 

Stone, clay and glass 5 13,977 5,557 0.8 642 1.2 6,035 1.0 8,655 92.0 9,400 

Fabricated metal products 15 35,388 14,041 1.3 1,209 2.2 14,753 2.5 11,613 95.1 12,202 

Metal cans and containers 5 18,581 7,361 1.0 363 0.7 4,554 0.8 20,278 161.6 12,545 

Cutlery, hand tools, 

screws, bolts 4 11,277 4,484 0.6 442 0.8 6,346 1.1 10,144 70.6 14,357 All other 6 5,530 2,196 * 404 0.7 3,853 0.7 5,435 56.9 9,537 
Table 11 - Continued 

Q.ialified : Compensation :Tax Expeooiture: Avercge 

R:>ssession: Tax Expenditure Employees of Employees 2/ :Tax Expeooiture:as a Percent of: Employee 

Number of Net Incane: Amount :Percent of: 

___________ :_C_o_r_po_r_a_t_io_ns_:_ ..... ($_0_0_0~) 1/: ($000) : Total : Nl.Dnber 

:Percent of Amount :Percent of: Per Employee Compensation :Compensation 

: Total ($000) : Total ($) of Employees ($) 

Machinery, except electrical 10 138,536 46,376 6.4 3,550 6.5 39,648 6.8 13,063 116.9 11,168 

Office, canputin;J, and 

accounting 4 106,479 33,646 4.6 2,947 5.4 33,066 5.6 11,417 101. 7 11,220 

All other 6 32,057 12,730 1.8 603 1.1 6,582 1.1 21,111 193.4 10,915 

Electrical machinery 70 287,951 113,652 15.6 10,665 19.6 113,512 19.3 10,656 100.1 10,643 

Rirlio, TV, carmunication 7 37 ,090 14,746 2.0 1,182 2.2 11,121 1.9 12,475 132.5 9,408 

Electronic canponents 19 55,695 21, 742 3.0 3,131 5.8 36,134 6.2 6,944 60.1 11,540 

All other 44 195,166 77 ,164 10.6 6,352 11. 7 66,257 11.3 12,147 116.4 10,430 

Instrunents, photographic 

goods and watches 19 36,400 14,392 1.4 1,697 3.1 17,117 2.9 8,480 84.0 10,086 

Scientific instrunents 7 7,784 3,040 * 517 1.0 4,871 0.8 5,880 62.4 9,421 

All other 12 28,616 11,352 1.6 1,180 2.2 12,246 2.1 9,620 92.6 10,377 

All other manufacturing y 26 141,485 50,180 6.9 4,362 8.0 51,048 8.7 11,504 98.3 11, 703 

Off ice of the Secretary 

Office of Tax Analysis 

* less than U.5% 

y Equals net incane fran the active conduct of a trcrle or business in a possession plus net qualified possession source investment incane. 

y Compensation of anployees was canputed by multiplyirg 1.221 times payroll. '!be 22.1 percent reflects the ernployer-paid portion of social security, 

unemployment insurance, and other non-payroll costs. 'llle 22.1 percent is the average for all U.S. manufacturing industries in 1978; see the U.S. 

Department of cannerce, Survey of Current Business, July 1979, Tables 6. 5 and 6. 6. 

Y C,anpensation of anployees and nunber of employees used to canp..ite these c:wnounts were weighted by industry usin;J the ratio of tax expenditure in Table 10 

an:i tax expeooiture in this Table • 

.Y Includes manufactur in;J industries where data were available for less than 3 oorpor ations. 

I 

~ 

\0 

I 
$40,000 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

No. of 

Employees 

-50-

FIGURE Ill 

Tax Expenditure Per Employee and Average 

Employee Compensation for Selected 

Manufacturing Industry Groups, 1978 

38,446 

D Tax Expenditure per Employee 

~ Average Employee Compensation 

14,382 

10,962 

8,807 

~ -...J 10,7431- ---+l 2,429 I--l 15,912 1-

Food and Kindred Chemicals Rubber, Leather, Machinery and All Othe~ g 

products, Apparel, Stone, Clay, Professional and Manufactt.1n11 

and Textile Mill Glass and Scientific 

Products Concrete Products Instruments 

Note: The height of the bars indicates the tax expenditure per employee and the average compensation per employee. 

Because the width of the bars indicates the number of employees, the area indicates total tax expenditure and 

total compensation. 
-51-

Figure III also indicates a direct relationship between a 

; company's tax expenditure per employee and its total compensation 

per employee. This reflects a tendency of the high-profit 

industries to employ more highly skilled workers and/or a 

willingness to pay those workers more than they would have been 

paid by other Puerto Rican employers. The chemical industry, 

which provided 20 percent of the total jobs in 936 manufacturing 

firms, paid 26 percent of the total employee compensation. 

The industries in which tax expenditure per employee were the 

highest (pharmaceuticals, electrical and electronic equipment, 

scientific instruments, and non-electrical machinery) tended to 

be the same industries in which total employment has been growing 

during the past decade. Conversely, industries in which tax 

expenditure per employee were the lowest (tobacco products, 

textiles, apparel, leather products) tended to be those whose 

employment was declining -- see Table 6, above. 

Table 12 is based on the same 301 possessions corporations s~own in Table 11, but ranked according to the Federal tax expenditure per employee. At the top of the ranking were nine 

companies for which the Federal tax expenditure represented more 

than $100,000 per Puerto Rican employee; at the low end were the 

companies which incurred losses and thus derived no immediate tax 

benefit from section 936. The top nine possessions corporations 

accounted for 11. 4 percent of the tax expenditure but only 1. 3 

Percent of the employment of the 301 manufacturing companies for 

Ylhich employment data were available. The top 28 possessions 

~orporations, those for which tax savings per employee exceeded ~so,ooo in 1978, collectively accounted for 37.4 percent of the 

total tax expenditure and 6.1 percent of total employment. 

D. Arthur D. Little Study 

Compensation and number of jobs are not the only measures of 

the benefits provided by 936 corporations to Puerto Rico. · Other 

~ea~ures include the skill level of the jobs, the opportunity for 

!~d1vidual employees to upgrade their skills, and the security of 

t Ployment. A study by the Arthur D. Little Company l!/ underc aken on behalf of clients in the pharmaceutical industry oncludes that: 

-

.!.!.I Arthur D. Little, Inc., "A Statistical Profile and Evaluation 

Of the Employment Impacts of the Pharmaceutical Industry on 

Puerto Rico," and "Socioeconomic Aspects of Employment 

Opportunities in Puerto Rico's Pharmaceutical Industry," 

Cambridge, Massachusetts, 1980. 
Table 12 

Tax Experrliture, Emplo~ent arrl canpensation of Employees by Size of Tax Experrliture Per Employee, 1978 

: Qualified : canpensation :Tax Experrliture: Average 

Size of 'l'ax Expenditure : i:ussession: Tax E~nditure E!!ElO:f:eeS of Emplo:t:ees 2/ :Tax Expenditure:as a Percent of Employee 

per Employee Nunber of : Net Incane: llroount : Percent of : Percent of: linount :Percent of: Per Employee Canpensation Canpensation 

:Coq~~rations: ($000)1£'.'.: ($000) : Total Ntmlber Total ($000) : Total ($) of Emplo:t:ees ($) 

All corporations 301 1,941,130 726,907 100.0 54,306 100.0 586,864 100.0 12,667 y 118.4 y 10,697 y ~luu,uuu or more 9 213,816 83,012 11.4 708 1.3 10,698 1.8 117,248 775.9 15,110 

~ su,ouu uroer $10U,U00 19 508,281 188,677 26.0 2,616 4.8 36,579 6.2 72,124 515.8 13,982 

$ lu,uuu urxier $ 50,UUU 97 925,030 343,113 47.2 16,854 31.0 218,659 37.3 20,357 156.9 12,973 

~ 5,uuu uroer $ 10,000 47 142,083 56,144 7.7 7,908 14.6 81,493 13.9 7,099 68.8 10,305 

~ 1, uuu urrier ~ 5,lJUO 93 137,905 52, 397 7.2 18,648 34.3 176,325 30.0 2,809 29.7 9,455 

:;, sou uroer $ 1,000 11 8,449 2,983 0.4 3,415 6.3 30,326 5.2 873 8.9 8,880 

$ luu urxier $ suo 17 1,457 568 0.1 2,649 4.9 20,802 3.5 214 2.7 7,852 

;; l uroer $ lllO 5 40 13 * 340 0.6 2,800 0.5 38 0.4 8,235 

No tax expenditure 3 4,069 1,168 2.2 9,182 1.6 7,861 

Office of the Secretary 

Off ice of Tax Analysis 

y &iuals net income frcm the active corrluct of a trcrle or business in a U.S. possession plus net qualified p:>ssession source investment income. 

2/ canpensation of employees was canputed by multiplying 1.221 times payroll. '!'he c:dditional 22.1 percent reflects the employer-paid portion of social 

- security, unemplo~ent insurance, arrl other non-payroll labor costs. '!'he 22.1 percent is the average for all U.S. manufacturing irrlustries in 1978; see 

the U.S. i:::epa.rtment of Ccmnerce, Surve:t: of Current Business, July 1979, Tables 6.5 and 6.6. 

Y Compensation of employees arrl nunber of employees used to ccmpute these amounts were weighted by industry using the ratio of tax experrliture in Table 10 

ai'rl tax experrliture in Table 7. 

* Less than u.1% percent 

I 

V1 

N 

I 
-53-

Pharmaceutical jobs are above average in skill level. As 

shown in Table 13, 38 percent of pharmaceutical jobs in 

Puerto Rico may be classed as "skilled," compared to 11 

percent in the apparel industry and 34 percent in the 

food industry. 

The pharmaceutical industry con tr ibu.tes more to "human 

capital formation" -- i.e., the development of the skills 

and knowledge of the labor force than do other 

industries in Puerto Rico. In a 1979 survey of 23 u.s.-

owned pharmaceutical firms, 15 had one or more "families" 

of jobs in which movement from a low-skilled to a highskilled position occurs when an employee successfully 

completes a company-sponsored program. In addition, 

several of the pharmaceutical companies surveyed indicated that they had provided technical assistance on an 

informal basis to a number of their suppliers. 

By virtue of its high profits, employment in the pharmaceutical industry is more secure than in the apparel, 

leather goods and other industries which are threatened 

by low-cost foreign imports. 

III. Estimates of Linkages and Multiplier Effects 

The preceding Section related the tax expenditure of the 

Possessions corporation system of taxation to the employment and P~yroll of those companies. In addition to creating jobs 

directly, this system of taxation may bring indirect benefits to 

Puerto Rico. The development of one industry may encourage the 

$towth of other industries that are users of the products which 1 t manufactures, a phenomenon called "forward 1 inkage." For 

example, the building of a petroleum refinery facilitates the 9: 0 wth of petrochemical manufacturers. Manufacturing alsq gives : 1 se to backward linkages. Production requires raw materials, 

~ntermediate goods and services, a portion of which are supplied j~bthe local economy. Investment in plant and equipment creates 

VJ 8 in the construction and capital equipment industries. 

s~tk~rs in all industries spend their salaries on goods and 

e rv1ces, which has a "multiplier" effect on the Puerto Rican 

conomy. g; 

-

.!l! A ~ a general practice, the Treasury does not estima.te. the lu~kage and multiplier impacts of specific tax prov1s1ons. 

This is because tax changes are usually taken in the context 

of an overall Federal budget. The purpose of undertaking the 

analysis here is to assess the impact of section 936, both in 

total and by industry, on Puerto Rico alone, not on the U.S. 

and Puerto Rico taken together. 
Table 13 

Distribution of Employment between Skilled and 

Unskilled Occupational Groups, by Industry in Puerto Rico, 1975 

Professional. 

Technica 1, 

Administrative, 

and Sales Personnel 

Craftsmen 

and Foremen "Skilled" 

Clerical 

and Service 

Operators Laborers Personne.1 •unskilledM 

Total * 

Employment 

Food and Kindred Products 

Tobacco Products 

Apparel and Textile Hill Products 

Paper and Allied Products~ Printing, Publishing, etc. 

Chemicals and Allied Products 

(Excluing Drugs) 

Drugs 

Petroleum Refining and Related 

Industries; Rubber and Plastics 

leather and Leather Products 

Stone, Clay, and Glass Products 

Metal Products 

Machinery (Except Electrical) 

Electrical Machinery 

Transportation Equipment 

Professional Instruments 

Miscellaneous Manufacturing 

14~ 

4 

3 

32 

27 

27 

11 

4 

12 

11 

18 

10 

12 

7 

9 

201. 

13 

8 

27 

15 

11 

21 

12 

18 

20 

30 

14 

27 

17 

13 

34,; 

17 

11 

59 

42 

38 

32 

16 

30 

31 

48 

24 

39 

24 

22 

44% 

67 

83 

25 

38 

42 

52 

75 

48 

55 

JA 

62 

49 

60 

64 

111 

8 

2 

3 

7 

6 

8 

4 

14 

8 

4 

5 

4 

4 

5 

111 

7 

4 

14 

13 

14 

8 

6 

9 

6 

11 

9 

g 

11 

9 

661 

82 

89 

42 

58 

62 

68 

85 

71 

69 

53 

76 

62 

75 

78 

22.950 

4,980 

40,973 

3,812 

4,651 

5,964 

5.364 

5, 161 

6, 169 

5,597 

3,469 

9.919 

414 

10,829 

2,888 

* Total employment in all manufacturing industries in 1975 was 136,617. Employment figures are for October. 

Source: La Demanda por Recurses Humanos en la Economia de Puerto Rico: Requisites Actuales y Projecciones 

para 1985, Consejo Asesor del Gobernador Sobre Politica Laboral, San Juan, 1978, Appendices; and 

Puerto Rico Department of Labor and Human Resources, 1975 Census of Manufacturing Industries of 

Puerto Rico. Reprinted from Arthur o. Little, Inc., "A Statistical Profile and Evaluation of the 

Employment Impacts of the Pharmaceutical Industry on Puerto Rico," Cambridge, Massachusetts, 1980, 

P• 40. 

I 

IJ1 

~ 

I 
-55-

A. Forward Linkages 

"Forward 1 inkages" 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, ~t 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 1972. Table 14 shows the 

Percentages of manufacturing industries' shipments in 1972 to 

Puerto Rico, the United States, and foreign countries, respectively, but does not distinguish between sales to individual 

consumers and sales to manufacturers. For manufacturing as a 

Whole, 41.2 percent of ship~ents went to Puerto Rico, 54.2 percent to buyers (including parent companies) in the United States, 

and 4.5 percent to foreign purchasers. If indirect exports 

(i.e., goods sold to other Puerto Rican manufacturers who, in 

turn, were exporting to the United States or foreign countries) 

could be estimated separately, Puerto Rico's dependence on export 

markets would appear larger than Table 14 indicates. 

Table 14 shows that some ind us tries' forward 1 inkages 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 

ana paper industries -- also sell almost exclusively to the local 

market. By contrast, the pharmaceutical industry and electrical 

ana electronic equipment industry sold 1 percent and 11 percent, 

respectively, of their total production to Puerto Rican buyers. 

Because pharmaceuticals and electrical and electronic equipment ~ccount for 80 percent of the business receipts of all 936 firms 

ln the manufacturing sector, the evidence of Table 14 · would 

~Uggest that possessions corporations are not generally an imporant stimulant to the development of "downstream" industries. 

B. Backward Linkages 

~ Backward linkages refer to the generation of income in 

p Upstream" (supplier) ind us tries as a result of an industry's 

aurchases of local goods and services. In order to estimate the 

imount of purchases in Puerto Rico by possessions corporations, 

cnfo7mation on the total purchases of individual industries was 

r.i0mP1led from preliminary data for the 1977 Economic Census of ~~f ac tu res, Pu er to Rico. Rather than assuming that every 
-56-

Table 14 

Destination of Shipments by Puerto Rican 

Manufacturing Industries, 1972 

(Percentage of total) 

Industry Puerto United 

GrouE Rico States 

All Manufacturing Industries 41.2 54.2 

Food and kindred products 59.2 37.2 

Tobacco products 15.5 84.5 

Textile mill products 28.7 71.3 

Apparel 21.8 78.0 

Lumber and wood products 100.0 

Furniture and fixtures 97.9 2.1 

Paper and allied products 87.5 5.0 

Printing and publishing 78.2 18.2 

Chemicals 18.9 66.5 

Pharmaceuticals 1.0 76.0 

Petroleum refining 64.2 32.7 

Rubber products 47.8 52.2 

Leather and leather products 15.6 83.1 

Stone, clay and glass products 91. 7 8.3 

Primary metal products 87.1 9.7 

Fabricated metal products 77 .1 22.2 

Machinery except electrical 35.2 so.a 

Electrical and electronic equipment 10. 7 87.9 

Transportation equipment 72. 7 9.1 

Scientific instruments 3.9 94.6 

Miscellaneous manufacturing industries 12.3 87.7 

Off ice of the Secretary 

Off ice of Tax Analysis 

Foreign 

1/ Countries_ 

4.5 

3.7 

* 

* 

* 

* 7.5 

3.6 

14.6 

23.0 

3.3 

* 

* 

* 3.2 

1.4 

14.8 

.2 

9.1 

2.3 

* 

Source: U.S. Department of Commerce, 1972 Economic Censuses of Outlying 

Areas, Manufactures, Puerto Rico, October 1974, Chapter 2, Table 3. 

Includes shipments to the Virgin Islands. 

* Less than 0.05 percent. 

i 

I 

\'1 

t 

j 

c 

t 

( 

t 

~ a 
-57-

industry's propensity to import was the same as that of the 

Puerto Rican economy as a whole, each industry's 1977 expenditure 

was apportioned using coefficients published in a recent study 

based on 1963 data. 13/ Between 1963 and 1977, the ratio of 

imported capital equipment, raw materials and intermediate products to gross domestic output increased substantially _!ii, so 

this procedure may overstate possessions corporations' dependence 

on the local economy. Moreover, because the operations of a 

possessions corporation are generally integrated with those of 

its U.S. parent, the linkage of possessions corporations with the 

Puerto Rican economy may be somewhat weaker than the linkage for 

all Puerto Rican manufacturers. 

The results of this procedure indicate that for all manufacturers the total expenditures on labor, materials, plant and 

equipment in Puerto Rico made up 42. 2 percent of the value of 

Production -- see column 1 of Table 15 and Table B-1, 1 ine 9. 

The results also show that some Puerto Rican industries depend 

much more than others on locally produced inputs. For example, 

food, furniture, paper, printing, stone, clay and glass manufacturers' expenditures on Puerto Rican inputs represent more than 

half of the total value of their own production. At the opposite 

extreme, the chemical and machinery industries spent less than 30 

Percent of the value of production on Puerto Rican inputs. The 

low chemical and machinery percentages reflect a high return on 

capital plus overhead costs as well as a slightly heavier than ~verage dependence on imported versus locally purchased mater-

:-a1s. (The chemical and machinery industries are estimated to ~mport 45 percent and 32 percent, respectively, of their total 

7nputs, compared to the 49 percent average for all manufacturing lndustries.) 

C. The Multiplier 

In addition to the income generated by payroll and pu~chases 

~f locally produced materials, expenditures by possessions cororations have a multiplier impact on the local economy. The 

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

1_3/ R' -- ichard Weisskoff and Edward Wolff, "Development and Trade 

Dependence: The case of Puerto Rico, 1948-1963," Review of 

.!£.onomics and Statistics, November 1975, Table 2, p. 474. 

l.11 Between 1963 and 1974, the ratio of Puerto Rican imports of 

capital goods, raw materials and other intermediate goods to 

9ross output increased from 29 percent to 41 percent. 
-58-

original increase in spending generates income, . part of which is 

used to purchase locally produced goods and services, thereby 

inducing a secondary increase in spending and income. According 

to standard textbook macroeconomic analysis, the size of the 

multiplier for an increase in spending (assuming, as seems 

reasonable in the case of Puerto Rico, that the government cannot 

change the rate of interest or credit conditions) is: 

1 

s+m 

The symbols s and m represent the fraction of an increase in GNP 

which is saved or is spent on imports, respectively. Saving and 

importing represent "leakages" -- the opposite of "linkages" -- from the spending-income cycle; the greater these leakages are, 

the more quickly the impact of increased spending is dissipated, 

and the smaller the multiplier is. 

In Puerto Rico, the propensity to save appears to be small, 

and the propensity to import high. Gross internal savings bY 

government, business and households in Puerto Rico has been 

negative since 1970. In 1978, imports of goods and services 

equaled 87 percent of gross national product; between 1976 and 

1978 the increase in the dollar value of imports equaled 91 

percent of the increase in the dollar value of gross national 

product. If the marginal propensity to save, s, is assumed to be 

zero and the marginal propensity to import, m, to be .90, then 

the formula given above indicates a multiplie~ of 1.11. That iS 

to say, if spending increases by $1.00, an additional $.11 in 

local spending will be subsequently generated, so the total 

increase in income is $1.11. _!2/ 

15/ The First and Second Annual Reports computed the value of rn 

using merchandise imports only, and on this basis arrived at 

a multiplier of 1.33. However, it is appropriate to compute 

m on the basis of imports of services as well as merchandise· 

Had this been done, the value of the multiplier would have 

been between 1. 0 and 1.1. In El Modelo Economico de Pue!.!£ 

Rico (San Juan, Inter American University Press, 1979), Jor9e 

Freyre estimates the value of the Puerto Rican "export multiplier" in 197 5 to have been 1. 06. That is, a one dollar 

increase in the demand for exports would have led to a total 

increase in Puerto Rican GNP of $1.06. 
-59-

D. Direct, Indirect and Total Effects 

Information on employee compensation provided by possessions 

corporations was presented in Section II, above. A broader 

measure of Puerto Rican benefits can be obtained by adding to 

employee compensation estimates of the companies' purchases of 

Puerto Ric an mater i a 1 s and new p 1 ant and equipment , and then 

incrementing the total spending on Puerto Rican inputs by the 

multiplier. The final result would be a measure of the total 

Puerto Rican income associated directly or indirectly with 

Possessions corporations. 

An assumption implicit in this new, broader measure is that 

all Puerto Rican resources used by the possessions corporations 

in their production have no alternative economic use they 

Would be unemployed but for the possessions corporations. 

Although this may be a reasonable assumption for the Puerto Rican 

labor used, other Puerto Ridan factors may be scarce. Water and 

land are scarce in Puerto Rico; their use by possessions corporations precludes their use in other sectors. Some purchased inPuts such as gas, oil, sugar, wood, or alcohol are standard comm?dities which must be bought, or could be sold, overseas. Waste 

disposal, transportation facilities, judicial services and other 

9overnment services may also have economic costs. If employee 

compensation by possessions corporations is too narrow a measure 

Of the benefits they bring Puerto Rico, the total income associated directly or indirectly with those corporations is probably 

too broad a measure. 

Table 15 shows for various manufacturing industries Federal 

tax expenditures as a percentage of (a) direct labor costs, (b) t~tal direct expenditures on Puerto Rican inputs, and (c) Puerto 

Rican income directly or indirectly associated with those 

7xpenditures, respectively. The first percentage (in column 2) ~s identical to that in Table 11 above, the second (in col·umn 4) 18 obtained by multiplying the first by the ratio of compensation 

~~.employees to total direct expenditures in Puerto Rico, and the 

ird (in the fifth column) by dividing the second by the ~~l tiplier. Finally, the last column is simply the inverse of 

i e. fifth column -- Puerto Rican expenditures directly or 

F'nddirectly generated by possessions corporations per dollar of 

e eral tax expenditure. 

· Table 15 indicates that Federal tax expenditure in some ~~dustries is associated directly or indirectly with more Puerto 

alcan expenditures or income than in other industries. The (~erage for all manufacturing is $3.50. In some industries 

·9., food products, apparel), the amount is between $9.00 and 
Table 15 

Tax Expenditures as a Percent of Canpensation of Employees, of Direct Expenditures in Puerto Rico, 

and of Direct and Indirect Expenditures in Puerto Rico, by Manufacturing Industries 

Industry 

Manufacturing industries 

Food and kindred products 

Textile mill products 

Apparel 

Chemicals 

Rubber products 

leather and leather products 

Fabricated metal products 

Electrical and electronic equipnent 

Scientific instrlJilents, photographic 

goods, and watches 

:Total Expenditures on 

: Materials, Plant and 

: Equipnent in Puerto 

: Rico as a Percent of 

:Value of Production 1/: 

42.2 

64.9 

41.6 

48.3 

29.0 

36.4 

38.6 

39.4 

33.8 

34.0 

Office of the Secretary of the Treasury 

Off ice of Tax Analysis 

y Fran Table B-1, line 9 

y Fran Table ll, collliln 10 

y Fran Table B-1, line lU 

4/ COllliln (2) times collliln 3 

y COllliln (4) divided by l. ll 

!ij Inverse of collJiln 5 

Tax Expenditure :Ratio of Canpensation:Tax Expenditure as :Tax Expenditure as Percent: Total Direct and 

as a Percent :of Employees to Total :a Percent of Total 

of Canpensation Direct Expenditures :Direct Expenditures : 

of Effiployees 2/ in Puerto Rico 3/ in Puerto Rico 4/ .. 

ll8.4 .265 31.4 

52.5 .180 9.5 

24.9 .457 11.4 

20.5 .596 12.2 

267.3 .197 52.7 

35.7 .604 21.6 

34.5 • 725 25.0 

95.1 .472 44.9 

100.1 .497 49.7 

84.0 .568 55.3 

of Total Direct and : Indirect Expenditures 

Indirect Expenditures in :in PUerto Rico Divided 

Puerto Rico 5/ : by Tax Expenditure 6/ 

28.3 3.5 

8.6 11.6 

lU.3 9.7 

ll.O 9.1 

47.4 2.1 

19.4 5.2 

22.5 4.4 

40.4 2.5 

44.7 2.2 

49.8 2.0 

I 

0\ 

0 

I 
-61-

$12.00, reflecting a low level of tax-exempt income and/or substantial purchases of goods and services from the Puerto Rican 

economy. In other industries the ratio is quite low, usually 

because the tax-exempt income is high and local purchases are 

only average. 

IV. Net Cost and Net Benefit 

As noted on page 32 above, the net cost and net benefit of 

the possessions corporation system should take into account any 

effects that the removal or restructuring of the Federal 

Provisions would have on Puerto Rican tax law and on the behavior 

of U.S. corporations currently (or potentially) investing in 

Puerto Rico. The net cost and benefit should also take into 

account the effect of these changes on the suppliers of ~ossessions corporations and on the level of employment and 

investment in Puerto Rico that would have occurred in the absence 

of the possessions corporation system. 

To illustrate both the importance of these issues and the 

difficulty of their resolution, Table 16 sets forth five possible 

reactions of U.S. corporations to reductions in Federal and 

Puerto Rican tax benefits provided to possessions corporations. 

The Table assumes not only that the Federal tax benefits are 

reduced, but also that Puerto Rico "mirrors" those changes in its 

tax law to ensure that any Federal tax liability on a U.S. 

corporation doing business in Puerto Rico is satisfied by a 

foreign tax credit for taxes actually paid to Puerto Rico. The 

Table assumes that present tax incentives are maintained for 

Puerto Rican-chartered subsidiaries of U.S. corporations because 

goreign (including Puerto Rican) subsidiaries are not subject to 

.s. tax on their unrepatriated foreign source income. These are 

the type of assumptions one must make to determine the net cost 

ana net benefit of the present tax system. · 

The possible reactions of U.S. corporations which are 

considered in Table 16 are: (1) no behavioral or legal change, ) reincorporating under Puerto Rican law, (3) moving operations 

f 0 ~ foreign country {e.g., . Ireland) and inco.rporating under (~)e1gn law, (4) moving operations back to the United States, and 

v· ceasing operations altogether. From the companies' point of 

f ~ew, each of these options has distinct disadvantages: the 

alrst and the fourth option result in paying taxes to Puerto Rico s~g.the United States, respectively; the second and the third may 

t Ject the corporation to substantial Federal toll charges on 

tansfers of property {including intangibles) to a foreign 
option 

1. No change in behavior 

2. Reincorporate as Puerto 

Rican corporation 

3. ~ve operations to foreign 

country; reincorporate as 

foreign corporation. 

4. ~ve operations to the 

united states 

5. Cease operations 

Off ice of the Secretary 

Office of Tax Analysis 

Table 16 

Possible Impact of Parallel Reductions in Federal and Puerto Rican 

Tax Benefits Provided to Possessions Corporations 

Impact on Federal Tax Collections 

~ne 

Increased by the toll charge on 

transfers of appreciated property 

and the tax on incane ranitted to 

the U.S. 

Increased by the toll charge on 

transfers of appreciated property 

and the tax on income ranitted to 

the U.S. 

Increased by amount of present 

expemiture plus aoount of tollgate 

and incane taxes presently paid 

to Puerto Rico 

~ne 

Impact on Puerto Rican 

Tax Collections 

Increased by amount of 

present tax expemiture 

~ne 

IDse present tollgate 

and incane taxes 

IDse present tollgate 

and incane taxes 

IDse present tollgate 

and incane taxes 

Impact on Employment and Investment 

in Puerto Rico 

~ change in present pattern 

~ chan::ie in present pattern 

Employment and investment lost 

(to foreign country) 

Employment and investment lost 

(to the U.S.) 

Employment and investment lost 

(to everyone) 

Note: It is assuned that Puerto Rican tax law regarding U.S. corporations (but not regarding Puerto Rican-incorporated subsidiaries of U.S. corporations) 

"mirrors" U.S. law, so that taxes paid to Puerto Rico will offset (via the foreign tax credit) any U.S. tax liability. 

I 

°' N 

I 
-63-

corporation, 16/ and result in an indefinite deferral of, but not 

a permanent exemption from, Federal taxes. Whether Federal or 

Puerto Rican tax collections actually increase depends on which 

option a corporation selects: Puerto Rico collects additional 

taxes under the first option; the Federal government may collect 

toll charges and income tax on profits remitted to the United 

States under the second and third option and collects the 

ordinary tax on income under the fourth. Finally under the first 

two options, Puerto Rico continues to benefit f~om the investment 

and em p 1 o ym en t b r o ugh t by U • S • in v e s tor s , bu t 1 o s e s tho s e 

benefits under the last three. The only way of determining to 

what extent the measured tax expenditure represents taxes 

actually foregone by the Federal and Commonweal th governments, 

respectively, and the measured employment and investment 

represent economic benefits which Puerto Rico would otherwise not 

obtain, is first to determine the extent to which corporations 

would choose each of these o~tions above the others. 

~/ The toll charge is the tax on the appreciation in value 

(market value less the basis in the hands of the transferor) 

of an asset transferred by a u .s. corporation to a foreign corporation. 
-64-

V. Impact of Changing from Section 931 to Section 936 and of 

Recent Changes in the Puerto Rico Tollgate Tax and Industrial 

Incentive Program 

As explained in Chapter 2, the possessions corporation system 

was modified in the period 1976 - 1978 by the Federal Tax Reform 

Act, the new Puerto Rican tollgate tax rules, and the 1978 

Industrial Incentive 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. This Section evaluates the impact of these changes on 

dividend repatriation, the Federal tax expenditure, and Puerto 

Rican tax revenues. Chapter 5, below, analyzes the ef feet of 

these changes on real investment in Puerto Rico. 

A. Dividend Repatriation 

Under section 931, the incentive to liquidate at the end of 

the exemption period was strong for possessions corporations i 

that was the only way for them to repatriate their earnings to 

their U.S. parent free of Puerto Rican and U.S. tax. The adoption of section 936 reduced the incentive to liquidate bY 

eliminating the Federal tax on distributed earnings. 

There has been a clear response in the repatriation of 

earnings. Before 1978, possessions corporations paid virtuallY 

no dividends to their U.S. parents. In tax year 1978, however' 

possessions corporations distributed $1.5 billion in dividends to 

their U.S. parents. Of this amount, approximately $950 million 

represented Puerto Rican source earnings and approximately $200 

million consisted of earnings on Eurodollar deposits. The 1978 

dividends represented one sixth of the $7.2 billion in retained 

earnings reported by 936 corporations, and 50 percent of current 

earnings -- see Tables 8 and 10, above. Puerto Rico estimates 

that annual dividend repatriations in the years ending June 1979 

and June 1980 were $1.4 billion. 

Thus, while 936 corporations have repatriated substantial 

dividends since 1976, they do continue to accumulate earnings in 

the possessions corporation. Qualified Possession Source Invest~ 

ment Income is effectively exempt from Federal and Puerto Rica~ tax, whereas income on comparable investments by the U.S. paren 

is not. Both U.S. and Puerto Rican law, moreover, exempts 
-65-

possessions corporations from the accumulated earnings tax. In 

addition, the Puerto Rican tollgate tax can be reduced by 

reinvesting earnings in Puerto Rican assets and can be avoided 

altogether in many cases by a liquidation. !:]_/ 

B. Federal Tax Expenditure and Puerto Rican Tax Revenue 

If the changes in U.S. and Puerto Rican law made the possessions corporation system more attractive to U.S. firms and thereby encouraged more to locate in Puerto Rico than would have done 

so under prior law, the Federal tax expenditure would have 

increased. If, on balance, they led to less investment in Puerto 

Rico, the tax expenditure would have decreased. In addition, the 

net tax expenditure would be reduced by the income and tollgate 

taxes paid to Puerto Rico under the new Puerto Rican laws. 

It is not clear from an examination of the changes in the 

U · S. and Puerto Rican laws whether the possessions corporation ~ystem provides more or less of an attraction to U.S. firms than 

it did before the changes. 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 Qualified 

Possession Source Investment Income, and by requiring firms to ~ake binding 10-year elections which carry a prohibition from 

~oining in a consolidated return. But it may have encouraged 

investment in Puerto Rico by allowing U.S. parent corporations a 

loo percent dividends-received deduction for dividends from a 

Possessions corporation, and not just a tax-free liquidation. 

Table 17 presents data on the number of companies that have 

made an election under section 936. As of June 1980, 750 ~orporations had filed a section 936 election form. Taken . 

0 9ether, these companies accounted for over 99 percent of the 

income excludable under section 931 in 1975. Since June 1979, 14 

additional U.S. firms have become possessions corporations. 

Almost half of the new electors were in electrical and electronic e~uipment. These elections were reacting to changes in Puerto !1 can law and to underlying Puerto Rican locational advantages as 

d e11 as to the adoption of section 936. No implication can be 

s~awn as to whether the number electing possessions corporation 

93 ~~us was higher or lower than it would have been under section 

-----

!2.1 The tollgate tax does not apply to liquidating distributions 

b¥ companies with "old" exemption grants or to liquidating 

distributions paid out of pre-1978 earnings by "converted" 

firms. 
-66-

Table 17 

Elections under Section 936 

Industry 

All Industries 

All Manufacturing Industries 

Electrical and Electronic 

Equipment 

All Other Manufacturing 

Non-Manufacturing 

Total as of 

June 1979 

736 

564 

109 

455 

172 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

New 

Elections*: 

14 

11 

6 

5 

3 

Total as of 

June 1980 

750 

575 

115 

460 

175 

* To alleviate hardship caused by the filing deadline set by 

temporary section 936 regulations, the final regulations allow a 

corporation which has made its election before April 9, 1980, to 

revoke that election for the first taxable year to which the 

election applies. No adjustment has been made to reflect cases in 

which corporations revoked prior elections. At least six 

corporations filed revocations, but several of these simultaneously 

filed new elections for later tax years. 
-67-

The main result of the complex changes made in Puerto Rican 

law -- both the tollgate tax and the new Industrial Incentive Act -- was to impose additional taxes on possessions corporations. 

Puerto Rico estimates that by 1983, the tax revenues generated by 

the partially exempt manufacturing sector currently operating or 

establishing operations in Puerto Rico will be $160 million. 

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. 

For some firms the new Industrial Incentive Act offers 

incentives not available under prior law. In particular, exportoriented 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 could convert to a new, 

Partially taxable status and receive a guarantee of an automatic 

10-year extension of the grant, 18/ whereas under prior law 

extensions (or the avail~bilityof a new grant) were not 

guaranteed. Firms in the textile, apparel, and shoe ind us tries 

Whose grants are scheduled to expire before 1983 are also to be 

allowed an additional five-year exemption of 90 percent of income 

taxes. 

Collections under the tollgate tax amounted to $49.1 million 

in the year ending June 30, 1978, which represents an effective 

rate of about 4.5 percent on $1.2 billion of Puerto Rican source 

earnings. (The tax does not apply to the $.2 billion in repatriated earnings from foreign countries.) Puerto Rico's tollgate 

tax receipts in FY 1979 were $65.0 million, and are anticipated 

to be $80 million in FY 1980. 

In addition to tollgate tax collections, Puerto Rico has 

begun to receive tax revenues from companies operating under the 

new Industrial Incentive Act, which provides for only a partial 

exemption from income tax for new or old "converted" firms. As 

of December 31, 1979, 531 firms had filed petitions to convert to 

Partial tax exemption. The number of applications filed 

~ePresented approximately 30 percent of all grants approved (for 

t36 and local Puerto Rican companies) and still in effect under 

he Prior Puerto Rican tax exemption laws. It is estimated that 

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

~/ As explained in Chapter 2, above, the 10-year automatic 

extension provides for 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. 
-68-

converted firms paid $15 million in income taxes to Puerto Rico 

in the year ending June 1979. Total income taxes due from all 

firms with partial tax exemption grants are estimated to be $25 

to $30 million in the year ending June 1980. 

Combining the above estimates of Puerto Rican tax collections 

from the tollgate tax and the income tax under the 1978 Industrial Incentive Act, it appears that together they will amount to 

slightly less than 4 percent of the qualified possession source 

net income of all manufacturing possessions corporations in 

calendar year 1979, and will rise somewhat in later years. 

Accordingly, the projected Federal tax expenditures for the 

period 1979-1984, shown in Table 1 above, have been reduced by 5 

percentage points, or from 38 percent to 33 percent of pretax 

income. 

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CHAPTER 5 

THE EFFECT OF 936 FUNDS ON THE PUERTO RICO CAPITAL MARKET 

I. Introduction 

The creation of section 936 by the Tax Reform Act of 1976 

induced U.S. possessions corporations in Puerto Rico to bring 

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

Eurodollar market. These funds are enormous by Puerto Rican 

standards. At the end of 1979, for example, 936 corporations had 

$2.9 billion in exempt CD's in Puerto Rican banks, which amounted 

to 34 per cent of all deposits in commercial banks. 936 deposits 

grew by $880 million in 1979, which would have been enough to 

finance more than 40 per cent of all gross investment in Puerto 

Rico. In total, financial investments in Puerto Rico by 936 

corporations enjoying exemption from Puerto Rican tax amounted to 

about $4.6 billion at the end of 1979. The equivalent on a U.S. 

scale would be in excess of $500 billion. 

Table 18 gives the financial portfolios of all 936 corporations in Puerto Rico. The financial assets listed do not include 

Working capital used in their own operations. Table 18-A 

Presents the financial portfolios of 936 corporations in 

manufacturing, that is, those also enj eying an exemption from 

Puerto Rican tax. The assets in Table 18-A are the principal 

focus of this chapter because the interest and dividends they 

fenerate can potentially be free both from U.S. and Puerto Rican 

ax . 

. This Chapter attempts to evaluate the impact of 936 funds, 

Which are continuing to grow because of unrepatriated earnings, 

on investment in Puerto Rico. There will first be a description 

~f the section 936 provisions regarding Qualified Possession 

tource Investment Income (QPSII) and of the Puerto Rican rules on 

dhe investment of Industrial Development Income. These together 

P etermine the financial investments that are exempt from both 

R~erto Rican and U.S. taxes. Because deposits in eligible Puerto 

ulcan banks are one of the important investments that are exempt 

u~der Puerto Rican and u .S. law, the regulations on the banks' 

t e of 936 funds will be discussed. The U.S. and Puerto Rican 

i~les have changed the way in which 936 corporations and banks 

b Vest their financial assets. Further changes can be expected 

fecause of the new Puerto Rican regulations on banks' use of 936 

t~nas' which became effective April 1, 1980. The remainder of 

tae Chapter will attempt to trace the effect of this rearth nge~ent of financial assets on real investment in Puerto Rico, 

inat is, on new plant and equipment, home building, and increased 

Ventories. 
-70-

Table 18 

Estimated Composition of the Financial Investments 

of Possessions Corporations at Year-end 1979 

Investment 

Total investments •..•..••..••••.....••.••.. 

Investments in Puerto Rico, total •••..•.••• 

Deposits in Puerto Rican banks •.•••.•.•• 

Puerto Rican source GNMA mortgages •....• 

Loans to other possessions corporations • 

Puerto Rican government obligations ..••• 

Repurchase - Resale agreements 

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 

$ billions 

6.3+ 

5.9+ 

2.9* 

1.0 

.l+ 

.2+ 

.3 

1. 2 

.2+ 

.4 

June 20, 1979 

*This includes about 7 5 million in savings banks. Some of the 

funds referred to as 936 deposits may include deposits by exempt 

firms who have not made a 936 election e.g. local exempt firms. 

These, however, are likely to be a small part of the total. 

l 

~ 
-71-

Table 18-A 

Estimated Composition of the Financial Investments 

of Possessions Corporations in Manufacturing 

(enjoying PR tax exemption) at Year end 1979 

Investment $ b1ll1ons 

Total investments •••••••.••••.••••••••••••• 

Investments in Puerto Rico, total 

Deposits in Puerto Rican banks 

. . . . . . . . . . 

Puerto Rican source GNMA's .............. Loans to other possessions corporations • 

Puerto Rican government o~ligations ••••• 

Repurchase - Resale agreements ••••..•.•• 

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 

5.0+ 

4.6 

2.9 

1.0 

.l+ 

.2+ 

.2+ 

.l+ 

.1 

• 4 

June 20, 1979 

Note: The Puerto Rican Treasury Department has mad'e available 

the following balance sheet information for the 374 

corporations whose data are given in Table 8 in Chapter 4. 

Cash (CD's) (Total - $1,589,740 

U.s. Obligations 

{GNMA SBA Federal project Notes) 

PR Government Ogligations 

Other current Assets (CD's, Repos) 

Mortgages or Real Estates Loans (GNMA, Repo) 

Other Investments (CD's, Repos, GNMA, etc.) 

$1,500,000 

228,189 

228,930 

432,359 

126,670 

2,517,426 

$5,033,574 
-72-

The link between a switch in financial holdings by 936 

corporations and an increase in real investment in Puerto Rico is 

not straightforward. A 936 corporation may,, for example, switch 

from Eurodollar deposits to a deposit in a bank operating in 

Puerto Rico. In turn, the receiving bank will invest the funds. 

The rules described below identify the "eligible" uses of these 

funds. The principal categories excluded are consumer loans, and 

assets and loans outside of Puerto Rico. Depending on the 

rigidity of the rules in force, and on whether it has more 

"eligible" assets than 936 deposits already, the bank will invest 

either in U.S. money market assets and consumer loans, or in 

"eligible" assets such as Puerto Rican government obligations or 

loans to businesses operating in Puerto Rico. If the bank 

invests in more "eligible" assets, the story does not, however, 

end there. For example, a firm receiving a loan might otherwise 

have obtained the funds from the U .s. money market. Receiving 

the money from a bank in Puerto Rico may therefore not necessarily affect its investment behavior. Further, the proceeds of 

a loan can be used for various purposes including increased 

financial investments. A large multinational borrower might also 

use the funds to finance investments outside of Puerto Rico. If 

the bank lends to the Puerto Rican government, the real impact is 

also not immediately clear. One possibility is that this lending 

may simply replace purchases of tax-free Puerto Rican debt bY 

U.S. residents, without much impact on the market for Puerto 

Rican government obligations. On the other hand, it may have the 

effect of lowering the interest costs of the Puerto Rican 

government and, perhaps, encouraging public investment. 

Because of this complexity in the relationship between 

financial investment by 936's and real investment in Puerto Rico, 

it will be useful to look at the issue from several vantage 

points. The empirical analysis begins with an examination of the 

change in capital flows into Puerto Rico in response to section 

936. These net flows are the result of both the acquisition of 

Puerto Rican assets by nonresidents and the acquisition of 

foreign (including U.S.) assets by residents of Puerto Rico. The 

relevance of these flows is that they should reflect the large 

inflow of funds brought about by section 936. If these funds in 

fact lead to an increase of investment in Puerto Rico, there 

would be an increase in net capital flows to Puerto Rico over 

what there otherwise would have been. The contribution of net 

capital inf lows to capital formation in Puerto Rico would be 

expected to rise. 

The empirical analysis then proceeds with a review of how 936 

funds have affected the banking system in Puerto Rico. Banks are 

intermediaries for the investment of about 60 percent of 936 

f 

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-73-

funds. As we shall see in the review of relevant statutes and 

regulations, this is in part due to the strategic position they 

are given in the Puerto Rican rules. Because of banks' 

importance in channelling 936 funds, the change in their 

portfolios in response to the inflow of 936 deposits will be 

examined. In other words, how was the increase in assets 

distributed among business loans, investments in Commonwealth of 

Puerto Rico obligations, and investments in the Eurodollar or 

U.S. money market? 

In addition to the look at bank portfolios, other areas of 

bank behavior are reviewed. One is the competitiveness of the 

market for 936 deposits. Deposits by 936 corporations are 

concentrated in a relatively small number of banks. What 

determines the interest rate that banks pay on 936 certificates 

of deposit? Are banks able to maintain a substantial discount on 

the rate they pay compared to regular deposits, or does the 936 

rate respond to market forces? Further, when banks are able to 

9et 936 deposits at a much lower cost than other sources of 

funds, is this reflected in the interest paid by Puerto Rican 

borrowers? These questions are relevant because they cast ~urther light on whether 936 funds reduce the cost of capital for 

investment in Puerto Rico. 

In addition to causing a large flow of funds into exempt bank 

deposits, section 936 and the related Puerto Rican legislation 

have also resulted in a shift of funds into other exempt assets. 

Two important categories are obligations of the Commonwealth of 

Puerto Rico and U.S. government guaranteed securities backed by 

Puerto Rican mortgages (GNMA's). The effect of 936 funds on the 

market for each of these assets, which differs because of their 

dtiffering attractiveness as 936 investments, are examined in 

urn. 

After this examination of the markets for specific types of 

exempt assets, the empirical analysis returns to an overall look 

~t investment flows in Puerto Rico. Specifically, is it likely 

P hat the 1 a r g e vo 1 ume of 9 3 6 funds co u 1 d be absorbed by the 

Uerto Rican economy in the form of increased real investment? ~ha~ is, are there enough profitable investment opportunities 

/ailable to prevent a leakage of 936 funds to higher rate of 

eturn areas? 

Finally, the Chapter concludes with a discussion of the 

gossible impact of the new regulations, effective April 1, 1980, 

overning the use of 936 funds by banks. 
-74-

II. LEGAL BACKGROUND 

A. Qualified Possession Source Investment Income Under 

Section 936 

Section 936, among other things, grants a credit which 

offsets the Federal tax on Qualified Possession Source Investment 

Income (QPSII) earned by a U.S. corporation making a 936 election. As explained in Chapter 2 above, QPSII is defined as 

gross income which is (a) from sources within a possession in 

which a trade of business is conducted, and (b) is attributable 

to the investment of funds derived from the active conduct of a 

trade or business in that possession. 

Section 936, in this respect, was an important change from 

the earlier section 931 which exempted all non-u.s. source income 

of possessions corporations. Financial investments by 931 firms 

were therefore made outside of Puerto Rico because the investment 

income would thereby be free from both U.S. and Puerto Rican 

taxes. For this investment income to continue to be free from 

U.S. taxes, section 936 required that they be invested in Puerto 

Rico. 

Final comprehensive regulations on QPSII have not been issued 

by the U.S. Treasury. A regulation covering deposits by 936's in 

Puerto Rican financial institutions has been issued. It exempts 

interest from deposits if they qualify for exemption from Puerto 

Rican tax under regulations issued by the Secretary of the 

Treasury of Puerto Rico, as in effect September 28, 1976, under 

authority of the Industrial Incentive Act. These Puerto Rican 

regulations are the subject of the next section. 

B. Puerto Rico Tax Exemption of Eligible Income Invested 

in Certain Assets 

The Puerto Rico Industrial Incentive Act of 1978 grants a tax 

exemption from Puerto Rican tax for investment income derived 

from the investment of Industrial Development Income in certain 

specified investments. For most investments, this exemption had 

existed in prior law as well. The investments that generate 

exempt interest, rents, and dividends (so-called 2(j) investments) are: 

Puerto Rico Government obligations and loans to the 

Government Development Bank or other government 

agencies, 
-75-

Mortgage loans or loans guaranteed by an agency of 

the Federal or Puerto Rico government, 

Loans to other exempt businesses, 

Loans to the maritime industry, 

Loans to small businesses operating in Puerto Rico 

which are guaranteed by the Puerto Rican or US 

governments, 

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 pμblic buildings including schools and 

hospitals, 

Nonredeemable preferred stock of banking institutions 

organized under the laws of Puerto Rico, and 

Fixed-term deposits 

institutions, 

in qualifying banking 

Al though this appears to be an impressive list, apart from 

the last item the opportunities for financial investments 

afforded to 936 's are relatively limited. Puerto Rican 

9overnment or agency bonds bear yields that are linked to the 

tax-free municipal market in the U.S. 936's do get the benefit ~f deferred and sometimes lower tollgate taxes by investing in 

Uerto Rican government obligations rather than repatriating 

their profits. But, because interest on such bonds is generally 

~Xempt from Federal tax, they don't realize the main potential ~nefits of the QPSII exemption, namely the tax exemption of a 

Yield which is high because it is taxable to other investors. ~=S· government-guaranteed securities (GNMA's) backed by Puerto 

lean mortgages are very desirable investments for 936's because 

~hey carry a high taxable (to others) return. However, new ~erto Rican GNMA issues amounted to only about $100 million in b.79~ which compares to a growth of 936 funds of about $1 

1

1 ll1on. Finally the market for loans by 936's to other 936's or 

p oc~1 exempt companies seems to be limited because exempt comf an1es can get funds for long-term f ~xed inve~tments at a t~x0 tee rate derived from the Puerto Rican version of Industrial 

A~~elopment Bonds. One agency that offers loans of this type. is 

c CA (the Industrial, Medical, and Environmental Pollution 0 ntro1 Facilities Financing authority). 
-76-

The banks in Puerto Rico, therefore, have a strategic position as intermediaries because Puerto Rican rules 

specifically allow them to take 936 funds and make any loan in 

Puerto Rico apart from a consumer loan. One example would be 

loans to Puerto Rican importers, wholesalers, or retailers, which 

a 936 could not make directly because trade is not an exempt 

activity. Banks can, therefore, make a much wider array of 

financial investments than 936's can themselves. 

Banks would, of course, be important intermediaries even 

without any legal advantages because of their experience in 

credit analysis, their willingness to put their capital at risk, 

and their ability to use their customers' 1 iquid i ty balances. 

The U.S. flow of funds data published by the Federal Reserve 

Board indicates that there is a relatively modest amount of 

direct lending from ultimate lender to the ultimate borrower. A 

change in the rules may therefore not have much effect on the 

banks' postion as intermediaries. Still, the possiblity of 

direct loans by 936' s to ultimate borrowers might have some 

effect on interest charges for bank loans. 

C. The Rules for Banks' Investment of 936 Funds Effective 

before April 1, 1980 

The Secretary of the Treasury in Puerto Rico can declare a 

depositary institution to be eligible to receive Industrial 

Development Income funds from exempted businesses. In order to 

assure that the 936 funds were used for the benefit of Puerto 

Rico, constraints were imposed on the banks. First, 20 percent 

of the funds had to be invested in obligations of the Puerto 

Rican government or its agencies, although banks were able to use 

their existing investments to satisfy this requirement. Two 

incremental constraints were imposed to prevent banks from using 

the remainder to make consumer loans or investments outside of 

Puerto Rico, which were classified as ineligible assets. First, 

the increase in consumer loans plus investments outside of Puerto 

Rico could not exceed the increase in non-936 funds. Second, the 

increase in 936 deposits had to be invested in an increase in 

eligible (i.e. nonconsumer and non-foreign) assets. 1/ The base 

period for each of these was April 30, 1975, the date-exempt CD'S 

were introduced under the Industrial Incentive Acts. In 

addition, Citibank and Chase were not permitted to reduce the 

amount of borrowing from their respective head off ices from the 

level on April 30, 1975. 

1/ These two constraints appear essentially equivalent. 

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-77-

However, there were several features of the way in which the 

banking regulations operated before April 1, 1980, which diluted 

the impact of the incremental rules: 

1. Warehousing. The Puerto Rican authorities realized 

that the sudden influx of 936 funds in 1976 could not immediately 

be absorbed within the economy. They, therefore, gave a bank 90 

days to invest 25 percent of a new deposit in eligible assets and 

180 days to invest 7 5 percent. Furthermore, because many CD's 

Were less than 180 days in term and were continually rolled over, 

they appeared to be amenable to the interpretation that they were 

"new" 936 deposits. The warehousing might therefore last 

indefinitely. (It is not clear whether any banks availed 

themselves of this interpretation.) 

2. End-of-the-month reportin~. Compliance with the 

Pre-April 1, 1980, rules was in terms o end-of-the-month levels. 

It was therefore possible for a bank to offer a CD for 29 days 

Yielding a month's interest, and let it disappear on the last day 

of the month. 

3. Repos (Securities sold under repurchase agreements). 

A banker could sell a Puerto Rican government obligation in its 

Portfolio to a 936 under a repurchase agreement (usually through 

an investment banker). 2/ The funds received by the bank were not 

considered 936 deposits~ To the 936, the Puerto Rican Municipal ~as an eligible (2j) investment. Furthermore, the bond that was 

repod" could still count as one of the banks' eligible assets • 

.!..t_would therefore count twice. }/ (There was some question as to 

-----------

3/ -

Under the usual terms of a repo, the seller (the bank) agrees 

to buy it back at a fixed date. It is therefore in essence a 

short term secured loan from the 936 to the bank. In Puerto 

Rican Treasury rulings, the character of the repo interest is 

the same as the coupon interest for the purposes of the 2(j) 

exemption. The sale and repurchase pr ice are therefore set 

to reflect the accruing interest during the repo, and to make 

the interest equivalent to a short-term yield. Since investment bankers in Puerto Rico are frequently intermediaries, 

there are in fact two back-to-back repos -- first between the 

~ank and investment banking house, and then between the 

investment banker and the 936 company. 

In April 1980 repos by all banks, including savings banks, 

amounted to $240 million, or about 7.5 percent of total 936 

funds in commercial banks. 
-78-

whether the bank or the 936 could claim the tax- free interest. 

Apparently, in some cases, both did.) ii 

4. Assets acquired from insolvent banks did not increase the 

base. 

Puerto Rico experienced a significant banking crisis in the 

mid 1970's. The most significant liquidation was Banco Credito 

which was the second largest bank at the end of 1975, with almost 

$800 million in assets. It was declared insolvent and its assets 

were taken over by other banks in Puerto Rico. Banks who 

acquired eligible assets from a liquidating bank could regard 

them as incremental. That is, the assets did not bring an 

addition to the base at the same time. 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 in 

the impact of increased 936 funds, there is the possibility that 

the incremental rules, even if strictly adhered to, would not 

affect banks' investments. The incremental rules would be 

effective only if the increase in 936 funds exceeded the increase 

in eligible investments that banks would have wanted to make 

anyway. If total 9 36 funds failed to increase, as occur red in 

calendar 1978, the normal growth in eligible loans would have 

made the incremental rule ineffective. Looking at this another 

way, the incremental rules don't have an impact if the growth in 

non-936 deposits relative to 936 deposits is greater than the 

"normal" growth in consumer and offshore loans relative to 

"eligible" loans. For example, if 25 percent of any growth in 

assets would be in the form of consumer and off shore loans in the 

absence of section 936, and non-936 funds represent more than 25 

per cent of the growth of assets, then the incremental rules 

impose no constraint. The ineligible loans could, in short, all 

be made from non-936 funds. 

ii A prospective 936 corporation would not claim the tax-free 

income if it were close to failing the 80 percent of gross 

income test because the tax-free interest is not included in 

gross income. However, if it could safely pass the 80 

percent test, it would prefer to have any exempt interest 

regarded as tax-free Puerto Rican government interest, 

because it has the added advantage of not being subject to 

the Puerto Rican tollgate tax when repatriated. 

be 

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-79-

In addition, these are opportunities for arbitrage by other 

borrowers. For example, a Puerto Rican firm which gets an 

"eligible" loan at preferred rates may choose to reinvest it at 

higher rates in U.S. CD's. The Government Development Bank may 

also avail itself of a similar opportunity. These various 

opportunities for arbitrage will be discussed later in this 

chapter. 

D. The New Banking Regulations Effective April 1, 1980 

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 in the previous Section. 

The main substantive changes were: 

1. A virtual end to warehousing opportunities. N~nety-five percent of 936 funds will have to be invested at all 

times in eligible assets. 

2. Compliance based on average daily balances during the 

month rather than end-of-the-month levels. 

3. Direct and indirect repos with 936 companies would be 

Classified as 936 deposits for the purpose of the investment 

regulations. 

4. In addition to the former requirement that 20 percent 

Of eligible funds be invested obligations of the Puerto Rican 

9overnment, a further 10 percent has to be deposited with the 

Government Development Bank. Banks will receive credit for 

existing loans to the GDB and repos to the GOB, which expects a 

net inflow of deposits of only about $50 million. 

d. The possible consequences of these new regulations will be 

iscussed at the end of this Chapter. 
-80-

III. Empirical Analysis 

A. The Inflow of 936 Funds and Net Capital Flows into Puerto 

Rico 

The Tax Reform Act of 1976, which created section 936, caused 

U.S. possessions corporations in Puerto Rico to bring back to 

Puerto Rico the very large pool of funds that had been invested 

in the Eurodollar market. As noted above, these funds amounted 

to about $3 billion in bank deposits by December 31, 1979, and 

J?erhaps, $5 billion in total. If this inflow caused a net 

increase in investment in Puerto Rico, it should have been 

reflected in a net increase in capital flows into Puerto Rico. 

The net contribution of external investment to the financing of 

investment in Puerto Rico would be expected to increase over what 

it otherwise would have been. 

Table 19 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 lg-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 flow back in anticipation of 

passage in the previous year. In any case, regardless of whether 

fiscal year 1977 or 1976 is taken as the beginning year for 

section 936 to have an impact, the net inflow of 936 funds iS 

hardly visible in the net capital balance. Total inflows in the 

last 4 years starting with fiscal 1976 are almost identical to 

the flows in the prior 4 years, even in nominal terms. Where d~ 

the $4-5 billion in 936 funds go? 

The answer is given on Table 20, which presents selected 

components of the 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 last four years 

is $3.8 billion higher than the total for the 4 prior years, or 

about the magnitude one would expect. 

The large increases in direct investment flows were offset in 

part by changes in banking flows. The three short-term bankini 

flows given in the table are changes in the foreign holding o 

non-deposit liabilities of Puerto Rican banks, changes in short' 

term investments by Puerto Rican abroad, and changes in foreign 
-81-

Table 19 

NET CAPITAL INFLOWS INTO PUERTO RICO* 

YEAR ENDING NET CAPITAL FLOWS 

June 30 (millions) 

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 1,212 

~SOURCE: Puerto Rico Planning Board, Bureau of Economic 

Accounts and Censuses 

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 1977 and 

1978. Furthermore, there were very large increases in invest-

~~~!~-~y_P~~£!£_Rl£~~-~~~~~-l~_f££el~~-£~£i ta!~m~£~~!~L articularl in 1977 and 1979. Presumably, these investments ~ere ma e up o Euro ollar or U.S. bank deposits. 

Changes in the holdings of Puerto Rican government 0 bligations were another offsetting factor. The foreign (largely ~:S:) accumulation of Puerto Rican government obligations 

lm1nished substantially in FY 1976. In part this was due to 

smaller total borrowing by the government. However, the creation 

Of section 936 must have played an important role. Some 936 

~<?rp?rations acquired Puerto Rican government debt. More 

19n1ficant were acquisitions by banks. As noted above, 20 

~bt~ent of 936 deposits had to be invested in government ~h ligations according to rules in force before April 1, 1980, 

en the requirement was raised to 30 percent. 
-82-

Table 20 

COMPONENTS OF THE PUERTO RICO CAPITAL ACCOUNT 

(in 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 nonresidents or Puerto Rican purchase 

of assets abroad] 

YEARS ENDING 

JUNE 30 

Direct investment 

in Puerto Rico 

Net short term banking 

flows 

Foreign holdings of 

bank debts 

Investment by PR 

banks abroad 

External deposits in 

Puerto Rican banks 

Net foreign investment 

in long term Puerto Rican 

Government obligations 

PR investment in U.S. 

Government securities 

Net foreign investment 

in short term debts of 

PR public corporations 

Short term investment 

abroad by public 

corporations 

All other 

Tota1. "Net 

1970 1971 1972 

330 686 626 

182 32 -25 

45 20 102 

-llO 79 -4 

247 -67 -123 

181 307 448 

-15 -20 66 

25 67 42 

- 7 - 2 -15 

195 86 181 

891. 1.,156 1,323 

1973 1974 1975 1976 1977 1978 1979: 

792 343 539 1,276 1,838 1,954 1,064 

ll4 39 306 59 -544 -2ll -440 

248 227 453 48 -91 -72 198 

-174 -25 -168 70 -457 -197 -763 

40 -163 21 -59 4 58 125 

404 590 896 208 353 -195 498 

15 lll 14 -32 -303 128 -94 

64 15 153 -37 105 - 6 -23 

8 -26 -96 -19 -48 -199 73 

-131 257 26 240 65 7 136 

1,266 1,329 1,838 1,695 1,455 1,478 1,212 

I-' ,.... . CJ) ,..... 
-83-

Other offsetting flows that were significant in some years 

include large Puerto Rican purchases of U.S. government 

securities in fiscal year 1977, and large short-term foreign 

investments by Puerto Rican public corporations in fiscal year 

1978. 

The overall picture presented by these balance of payments 

statistics is that, at least between June 30, 1976 and June 30, 

1979, section 936 and the related Puerto Rican regulations failed 

to lead to any visible net inflow of capital fnto Puerto Rico. 

Section 936 did bring substantial funds back to Puerto Rico, but 

these just appear to have flowed back out through the banking 

system and switches in the ownership of Puerto Rican public debt. 
-84-

B. The Change in Bank Portfolios in Response to the Inflow 

of 936 Funds 

936 deposits amounted to $2,862 million on December 31, 1979, 

which was 34 per cent of all deposits in commercial banks. ~/ 

How did commercial banks respond to this large inflow of 

deposits? To what extent did they increase loans and to what 

extent did they make other adjustments in their portfolios? 

Table 21 presents the balance sheet for all commercial banks 

in Puerto Rico on December 31, 1979, for the purpose of 

introducing an analysis of banks' portfolios. While there is no 

precise match of the listed assets with the category of 

"eligible" loans and investments, it is possible to form a good 

idea of where particular items fall. The large item in the first 

group of cash assets, "balance due from other banks," is largelY 

deposits by banks in the U.S. or the Eurodollar market. Only a 

small portion can be deposits in other Puerto Rican commercial 

banks because under "liabilities," we see that "deposits due to 

other banks" are relatively small and even these may include 

deposits by banks outside of Puerto Rico·. Deposits with the 

Government Development Bank, which are also included in "balance 

due from other banks" appear to be less than 10 percent of the 

total. On December 31, 1979, the GDB listed certificates of 

indebtedness issued to banks of $158 million. "Bonds and other 

investments" include bonds issued by both the Commonweal th of 

Puerto Rico and by the various levels of governments in the u.s. 

Only the former, issued by the Commonwealth or its agencies, are 

"eligible" assets. Information on this eligible category iS 

available separately and is also discussed below. Proceeding to 

the loan items, the first three categories are predominatelY 

eligible assets. The one important category which includes manY 

ineligible assets are loans to individuals. 

5/ There is some question whether this total is understated in 

view of the possibility of repos, mentioned earlier. On the 

other hand, the totals may be overstated because of 

redeposits in that the same 936 deposit is counted both in 

the bank receiving the deposit directly and in the bank in 

which it is redeposited. The data that are now available for 

the month of April 1980, indicate that these two almost 

exactly offset each other. In commercial banks there were 

$185.5 million in repos and $224.4 million in redeposits. 

For the purposes of this Section on overall portfolios, the 

"unadjusted" data will be used. Data on repos and redeposits 

is presented in the next Section. 

I 

l.f) 

~ 
-85-

Table 21 

Consolidated Report of the Condition of All Camnercial 

Banks Operati1"¥3 in Puerto Rico at the close of Business December 31, 1979 

Assets Totals 

Cash & Due Fran Banks •••••••• 

a) Currency & Coin ••••••• 

b) Checks on Bank in Puerto Rico 

c) Other Cash Items •••••••• 

d) Balance due fran other Banks 

9,922 

2,087 

108 

136 

11 

1,831 

(millions) 

L1ab1l1 ties 

Total Deposits • • • • • • • • • • • • 

Public Funds • • • • • • • • • • • • 

a) Secretary of the Treasury 

b) PR Government Instrumentalities 

c) Municipal Government of PR •••• 

d) Court of Justice •••••••••• 

Totals 

Borrls and Other Investments 

Loans & Discounts: 

1,467 e) U.S. Government Including Postal Savings 

a) Real Estate •••••• 

b) Agricultural ••••• 

c) Corrmercial & Industrial 

d) Loans to Individuals 

e) Overdrafts 

f) All other • • • • • • • 

Total Loans & Discounts 

Less: Valuation Reserve 

Total Loans & Discounts, Net • 

Bank Premises Owned • • • • • • • 

Real Estate Other Than Bank Premises 

Furniture Fixture & Equipnent 

Customers Liability on Acceptances 

Letters of Credit and of Guaranty • 

Interest in transit with branches 

Interest Earned but not collected 

Due fran head off ice of branches 

Other Assets • • • • • • • • • • • • • • 

Net balance fran current period 

Operations • • • • • • • • • • • • • • • 

1,181 

174 

2,297 

1,320 

102 

419 

5,494 

(40) 

5,494 

62 

111 

18 

117 

36 

112 

199 

256 

4 

Source: Government Developnent Bank for Puerto Rico 

f) Others • • • • • • 

Private Funds ••••••• 

a) Demand Deposits • 

b) Time Deposits: 

Savings Accounts 

Certificate of Deposits 

Time Deposits Open Accounts • 

936 FUI'lds • • • • • • • • • • • • • • • 

c) Certified, Dividend Officers 

Checks & Other Deposits 

d) Foreign Accounts 

e) Due to Other Banks • 

Bills Payable & Rediscounts 

Liability of these Banks on Acceptances, 

Letters of Credit and of Guaranty .•• 

Items in transit with branches •• 

Interest collected but not earned 

Due to head office •••• 

Other liabilities 

Other valuation Reserve 

Capital Notes ••• 

Capital Accounts • 

9,922 

8,344 

598 

108 

292 

101 

39 

14 

44 

7,746 

1,320 

1,312 

1,122 

156 

2,862 

201 

237 

537 

606 

117 

86 

156 

129 

154 

0 

48 

283 
-86-

The liability side of the balance sheets displays the various 

sources of funds to the banks. 936 funds stand out as an 

important item and are 37 percent out of all private deposits. 

It should be noted that banks are not simply passive recipients 

of funds but can attract various types of deposits by offering 

higher interest rates or providing better facilities. Two 

categories which are particularly susceptible to bank control are 

regular certificates of deposit and deposits by other banks. 

In order to see how the inflow of 936 funds affected bank 

portfolios, Table 22 presents balance sheet information for the 

banks on June 30, 1975, and on December 31, 1979. Total 

deposits, including 936 CD's, increased by 78.2 percent. But 

even this large increase understates the increase in potentially 

available funds because banks chose to reduce deposits by other 

banks from $817 million to $537 million over this period. 

Further, regular CD's increased modestly, presumably because 

banks didn't have to bid agressively for them with all the 936 

funds available. 

Total loans increased by 36.0 percent, which is about equal 

to the rate of increase in regular demand and savings deposits in 

the period. In other words, total loans increased much less than 

the increase in total deposits, including 936 CD's. How much 

would loans have increased without the inflow of the 936 funds? 

It is difficult to believe that the increase would have been much 

less than actually occurred. Total loans of all U.S. commercial 

banks increased by more than 60 percent in the same period, in 

part because of the strong cyclical recovery. The 36 percent 

increase in loans also seems moderate in view of the 40 percent 

increase in nominal Puerto Rican GNP in the four years from 

fiscal year 1975 to fiscal year 1979. 

Some of the other balance sheet changes are worth noting· 

The most dramatic is the increase in balances with other banks, 

which as noted above are primarily CD's in u.s. banks. This iS 

entirely consistent with the data on capital flows described in 

the previous Section. 

Banks operating in Puerto Rico increased their holdings '?f 

Puerto Rican government obligations by 149. 8 percent, which 1 5 

more in line with the expansion of resources resulting from the 

inflow of 936 funds. Not only are these eligible assets but, as 

indicated earlier, Puerto Rican regulations required that 20 

percent of 936 funds be invested in Puerto Rican government debt· 

m 

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-87-

s It is also worth noting that loans to individuals, which 

n might be expected to grow slowly because of the restrictions on 

the use of 936 funds for consumer loans, in fact grew much faster 

s than commercial and ind us trial loans. This might reflect the 

g relative importance of the demand for various kinds of loans and 

o of their profitability, compared to the role of the incremental 

e regulations. 

Table 22 also indicates that while the rules governing the 

k use of 936 funds may have imposed some cons tr.a in ts, they left 

substantial flexibility. Total holdings of Puerto Rican govern1 ment obligations and of all loans (including consumer loans) grew 

t by a total of $1. 9 billion from June 30, 1975 to December 31, 

1979. There may also have been an increase of $200-$300 million 

c in eligible assets in other categories, including deposits with 

the GDB. On the other hand, some of the loans are ineligible. 

e Eligible assets probably rose by at most $ 2. O bill ion. This 

compares with a growth of 1 936 deposits of $2.9 billion. The 

growth in "eligible" assets was therefore substantially less than 

the growth in 936 funds. 

This is not to say that Puerto Rican banks abused the 

opportunities available to them in the pre-April 1, 1980 

regulations. It was apparently not difficult for them to comply 

~ith the new regulations. Data that are now available from the 

new reporting system for banks indicates that commercial banks 

reported an increase of $3.4 billion of "eligible" assets between 

May 1, 1975 and April 1980. This is very close to the total 

amount of 936 funds including repos. There are several reasons, 

?es ides timing, for the discrepancy between this $3. 4 billion 

~ncrease reported by banks and the $2.0 billion we estimate using 

able 22. One is that Table 22 looks at the banking system as a 

~hole. On the other hand, a Puerto Rican bank can record an 

~crease in eligible assets by taking over assets from a bank in ~iquidation, even through aggregate eligible assets have not 

increased. These liquidations have been very · significant· since 

1975. Another reason for the discrepancy is that banks may 

Choose not to report write-offs of bad loans for the purpose of 

reporting compliance with the regulations to the Puerto Rican 

Treasury because it would reduce the amount of "incremental" 

~ssets. There appears to have been significant write-offs in 

Uerto Rico, particularly of real estate and constructions loans. 

f Summing up, it appears that the $2.86 billion inflow of 936 

Unds had at most a modest impact on the expansion of nonyovernment loans by banks operating in Puerto Rico. The growth 

9

n loans of about 7 percent per year was much less than the rapid 

rowth in total funds made possible by 936 deposits. 
-88-

Table 22 

Selected Assets and Liabilities of All 

Commercial Banks in Puerto Rico 

June 30, 1975 

Total Assets 5,782 

Balances Due from 

Other Banks 441 

Total Obligations of 

Commonwealth of PR and 

Political Subdivision * 275 

Total Loans and 

Discounts 4,009 

Demand and Savings 

Deposits 1,893 

Total Deposits 4,682 

Deposits Due to Other 

Banks 817 

Non 936 CD's 991 

Total Deposits Excluding 

Due to Other Banks 3,865 

Total non 936 Deposits 4,682 

Commercial and 

Industrial Loans 1,586 

Loans to Individuals 654 

Dec 31, 1979 

9,922 

1,831 

687 

5,454 

2,632 

8,344 

537 

1,122 

7,807 

5,482 

2,297 

1,320 

Percent Chan~ 

+71. 6 

315.2 

149.8 

36.0 

39.0 

78.2 

-34.3 

13.2 

102.0 

17.l 

44.8 

101.8~ 

* Does not include deposits with GDB, which are included iJ1 

"balance due from other banks." 

a 

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-89-

One reason given for the restrained growth in loans by Puerto 

Rican banks, even with huge inflow of 936 funds, is the need to 

restore their liquidity position after the 1975 recession and the 

banking crises that followed. This may have been true at first, 

but by now the liquidity position of Puerto Rican banks is far 

superior to that of U.S. banks. On December 31, 1979, cash items 

-- including deposits in other, mainly U.S., banks were 21 percent 

~ of total assets in Puerto Rican banks, compared to 14 percent in 

US banks. Loans and investments were 69. 8 percent of total 

assets in Puerto Rican banks, compared to 83.7 in U.S. banks. ~/ 

It appears that Puerto Rican banks have historically maintained a 

relatively liquid asset position. Nevertheless, as a percentage 

of assets, cash items are now higher, and loans and investments 

much lower, than at the beginning of the 1970's. 

Another reason frequently given by bankers for their reluctance to use 936 funds for loans to Puerto Rico business is that 

they view 936 deposits as "short-term" money. The 936 deposits 

come in big blocks, mostly for ninety days or less, and may 

quickly be withdrawn because of the parent's investment needs. 

The Puerto Rican bankers seem to be very sincere in this view, 

but it bears some examination. First, 936 deposits have con-

~inued to grow and no bank has suffered significant withdrawals. 

0 reover, long-term deposits are not completely insignificant. 

In May 1980, deposits with terms of 5 or more years (some with 

floating rates) amounted to $589 million, or more than 18 percent 

6/ 

- If the 83. 7 percent ratio were applied to total assets in 

Puerto Rican banks, it would mean about 1.4 billion more in 

loans and investments or about half of the 936 deposits. We 

have also seen that total assets would have been larger if 

banks had maintained their balances due other banks. Under 

normal circumstances, loans would therefore have been at 

~east $1. 5 billion larger. If one further remembers the 

increase in investment in government obligations, one 

concludes that only a relatively small increase in 

nongovernment loans took place due to 936 funds. 
-90-

of 936 funds. Also, why don't banks make floating rate loans 

linked to the '936 CD rate? If the 936 funds are suddenly 

repatriated, the 936 CD interest rate will become equivalent to 

the regular CD rate, which in turn tends to be linked to the 

Eurodollar rate. In other words, funds would always be 

available, al though sometimes not a discount from the regular 

cost of funds. It appears that there are more likely 

explanations for the modest growth in loans. Either banks are 

unwilling to link their lending rates to the costs of 936 funds, 

or there aren't sufficient creditworthy loans available, or banks 

have more profitable uses for the funds. 
-91-

C. The 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, and since 1978, Bank of America. Another group 

are the Puerto Rican. Banks, the largest of which by far is Banco 

Popular with $2. 4 billion in assets at the end of 1979. Even 

then, Banco Popular would only be about 50 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 Carribean. There are also 

foreign-controlled banks which are organized as Puerto Rican 

subsidiaries and are classified as domestic Puerto Rican banks. 

These include Banco de Santander and Scotiabank de Puerto Rico. 

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. 7/ This high degree of risk 

aversion may not be surpr1s1ng or- irrational in view of the 

Puerto Rican bank failures in the mid-1970 's. 8/ Whatever its 

cause, the conservative financial policy is reflected in the 

concentration of 936 funds that is evident in Table 23. The Chase 

and Citibank branches, which have their parents' capital behind 

them, alone account for 46 percent of all 936 deposits although 

they only have 27 percent of non-936 deposits. By contrast, the 

local banks have a much smaller share of 936 deposits than of 

total deposits. 

In addition to direct deposits by 936 corporations, the local 

commercial banks also get redeposits of 936 funds from national 

~anks with insufficient eligible loans. These redeposits are 

l.ncluded in the distribution of 936 funds in Table 23. 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. 

~/ Banco Credito, the second largest local bank at year-end 

1975, was declared insolvent and its assets were distributed 

to other banks. Banco Central 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. 
-92-

Table 23 

Distribution of Bank Deposits 

in Puerto Rican Banks, December 31, 1979 

(dollars in millions) 

:936 Deposits as:936 Deposits as: 

936 Total a Percentage : a Percentage 

Bank Deposits Deposits: of Total :of 936 Deposits: 

Deposits : in all Banks 

Chase 629 1,466 42.9 22.0 

Citibank 686 1,327 51. 7 24.0 

Bank of America 261 329 93.3 9.1 

Subtotal: 

National Banks 1,576 3,122 50.5 55.l 

Banco Popular 348 1,955 17.8 12.2 

Banco de Ponce 201 912 22.0 7.0 

Scotiabank de PR 228 426 53.5 8.0 

Subtotal: 

All Domestic 

Commerical 886 4,546 19.5 31. 0 

Royal Bank of 

Canada 191 459 41. 6 6.7 

Bank of Nova Scotia 209 216 96.8 7.3 

Subtotal: 

Canadian Banks 400 675 59.3 14.0 

Total: All Commercial 

Banks 2,862 8,344 34.3 100 

Note: Deposits of the smaller domestic banks are not 

displayed individually on the table. Their deposits 

are reflected in the subtotal for domestic commercial 

banks. 

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-93-

banks can also attract funds from 936's by offering repos (repurchase agreements) • These local banks, which tend to have an 

excess of eligible loans, do not need repos for the purpose of 

dealing with the banking regulations discussed earlier. But the 

security which is used for the repo provides collateral to the 

936 corporation. If the bank should fail, the 936 will be left 

With the underlying security. 2/ 

Table 24, which is based on the reporting system for banks 

Under the new regulations, reveals the significance of repos and 

tedeposi ts for each type of bank. It is clear that the local 

commercial banks were the prime beneficiaries of repos and 

tedeposits. About one third of their total 936 funds come 

~hrough these channels. The smaller local banks, which are not 

lndividually listed, received $200 million of their $300 million 

in 936 funds through redeposits and repos. 

Even though Chase and Citibank account for almost half of 

total 936 deposits, there are a number of other banks with 

Substantial deposits. Furthermore, the combined Citibank and 

Chase share has been falling in the past two years. In December 

31, 1977, they had 59.4 percent of all 936 deposits, compared to 

46 percent at the end of 1979. This erosion in their position is 

the result of several forces. One is the entry in 1978 of the 

~ank of America, which had acquired $261 million in 936 funds by 

he end of 1979. 10/ Another is the growing strength of Banco i0 Pular, which crossed the $100 million in capital threshold in 

978 and bid agressively for 936 deposits in 1979. The Canadian 

~anks are also becoming more prominent. Their parents are large 

nternational banks with capital sufficient to reassure the 

~teasurers of 936 companies. The Bank of Nova Scotia now has a 

bUerto Rican subsidiary (Scotiabank de Puerto Rico), as well as a 

t ~anch, and the Royal Bank is seeking approval for the acquisit~on of the Banco de San Juan. For these reasons it appears that 

lt\ e market for 936 deposits has become more competitive . . This 

t~y have contributed to the virtual elimination, for a time, ?f 

e e interest rate differential between 936 and regular CD's in 

n ar1y 1979. This differential is discussed more fully in the 

ext Section. 

"--------

~/ However, repos are not entirely satisfactory from the banks 

lo; 

Ji>oint of view because the margins have to be split with 

investment bankers, who usually arrange the repos or are used 

as intermediaries. 

Bank of America is confined by law to wholesale banking. 

That is, it cannot take deposits smaller than $300,000. 
-94-

Table 24 

Distribution of 936 Funds from All Sources 

Average Daily Balances, April 1980 

(preliminary data) 

Bank 

Chase 

Citibank 

Bank of America 

Subtotal: 

National Banks 

Banco Popular 

Banco de Ponce 

Scotia Bank de PR 

Subtotal: 

Direct 

Deposits 

654 

734 

310 

1,698 

358 

215 

125 

All domestic Commercial 789 

Royal Bank 

Bank of Nova Scotia 

Subtotal: 

Canadian Banks 

Total: 

258 

212 

470 

All Commercial Banks 2,957 

(in millions) 

Funds Obtained 

by Repurchase 

Agreements 

86 

14 

185 

185 

Redeposits 

7 

21 

59 

209 

15 

15 

224 

Source: Department of the Treasury of Puerto Rico 

Total 936 

Funds 

654 

734 

311 

1,699 

450 

250 

184 

1,183 

258 

227 

486 

3,142 * ~ 

* Includes only direct deposits and repurchase agreements. Including 

redeposits would count the same funds twic·e for the banking system as a 

whole. 

In April 1980, savings banks had $31 million of redeposits, $47 mill~on 

through repos, and $3 million of redeposits. All banks, including 

savings banks therefore had a total of $3,220 in 936 funds. 

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1 
-95-

D. The Interest Rate Differential Between 936 Deposits and 

Regular CD's: Is the Market for 936 Deposits Competitive? 

The interest rate that 936 corporations are able to obtain on 

their deposits in Puerto Rico banks is the result of several 

factors: 

1. Other investment opportunities available to 936's. 

As we have seen, the opportunities for non-bank investments are 

relatively limited. Puerto Rico source GNMA' s are desirable 

because of their guarantee and their yield, but the supply is 

inadequate relative to the volume of 936 funds. The one 

alternative market for 936 's which is liquid and very large is 

the Eurodollar market. However, Eurodollar interest would be 

taxable in the U.S. although it would be free from the Puerto 

Rican tollgate tax. We can see approximately how large the 

return on 936 deposits would have to be compared to the Eurodollar interest rate in order for banks to continue to attract 

936 funds. For example, assume a marginal U.S. corporate tax 

rate of 46 percent, a Puerto Rican tollgate tax of 10 percent, 

ana 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 after Federal income taxes. 

Therefore the 936 rate would only have · to be 60 percent of the 

Eurodollar return, that is .54 divided by .9, in order to be an 

acceptable alternative. 

2. The constraints on the use of 936 funds imposed b 

law and regulations, an t e ratio o e igi e oans to 

~osits. Section 936 and the Puerto Rican rules set guidelines 0 n how 936 funds can be used. The effectiveness of these legal 

constraints is reflected in how closely 936 funds and "eligible" ~oans have to be matched. If they have to be matched closely, 

hen banks' ability to bid for 936 deposits depends on the 

:vailability of creditworthy "eligible" loans. If the supply of 

eligible" loans is large relative to 936 deposits, then the 

?anks will bid the 936 CD interest rate up. Conversely, if there 

;s a large growth in 936 funds without a simultaneous growth in 

feligible" loans, then banks will be unwilling to bid agressively 

9or these funds because they wouldn't be able to place them. T~e 

t 36 CD interest rate would therefore begin to drop. That, in 

turn, would accelerate repatriation. Banks may also be induced 

Fo make more "eligible" loans as the cost of funds drop. 

Urther, more 936 funds may flow to the smaller local banks which 

Usually have an excess of eligible assets. 
-96-

3. The degree of competition by banks for 936 funds. If 

banks are competitive in bidding for 936 funds, they will bid for 

deposits as long as they have eligible assets and the 936 CD rate 

gives them at least a "normal" spread. If there were an excess 

of eligible loans, the 936 rate would approach the regular CD 

rate. On the other hand, if a single bank or limited number of 

banks had dominant positions, they would be able to obtain 936 

funds as long as they paid marginally above the after-tax 

Eurodollar rate. They would maintain the spread between 936 and 

regular CD's even if the banking regulations imposed no effective 

constraint on the use of the money. 

Table 25 presents data on interest rates for 936 CD's and for 

regular CD's. (The rate on regular deposits differs from the 

Eurodollar rate by only a small margin). The percentage 

difference between 936 and regular CD interest rates was 

relatively stable between December 31, 1976 and June 30, 1978. 

The differential then started to drop and virtually disappeared 

by March 1979. It proceeded to widen again in the following 12 

months. 

This movement in the differential between 936 and regular CD 

rates is consistent with the growth in loans relative to the 

growth in 936 deposits. They are given in Table 26. Loans grew 

pretty steadily over this period at the rate of $400-$500 million 

per year. (Because there is a seasonal element in loans, it is 

better to compare levels in the same month of the year.) On the 

other hand, 936 deposits were relatively stable from December 31, 

1977 to December 31, 1978, growing by only about $250 million. 

Therefore, over the period banks had many additional uses for 

936 deposits, but deposits had not grown much. They therefore 

bid the interest rate on 936 CD's up close to the rate on regular 

CD's. By contrast, between the end of 1978 and the end of 1979, 

936 deposits grew by almost $900 million, much faster than the 

growth in loans. The most rapid growth was in the last nine 

months of the year. As 1979 progressed, therefore, banks 

received many more deposits than they could put to use in 

eligible loans. They were therefore unwilling to pay high rates 

for additional 936 funds, which explains the widenin9 

differential after March 1979. 

The conclusions that can be drawn from these data: 

1. The market for 936 deposits appears to be relativelY 

competitive. The banks could not maintain the discount for 936 

deposits that existed in 1976 and 1977, but saw it almost disappear in early 1979. If the market for 936 funds was tightlY 

controlled, the banks would have been able to maintain a discount 

on 936 deposits that would leave a return just slightly high:r 

than the after-tax Eurodollar rate. Table 25 indicates that this 

has not been the case. 

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-97-

Table 25 

Comparison of 936 and Regular CD Interest Rates 

(3 Month Deposits) 

(B) (A) Regular Ratio of. 

Beginning of Month 936 CD Rate CD Rate A to B 

12/76 3.10 4.50 .69 

3/77 3.125 4.75 .66 

6/77 3.50 5.25 .67 

9/77 3.75 5.875 .64 

12/77 4.30 6.25 .69 

3/78 4.125 6.50 .63 

6/78 4.875 7.20 .68 

9/78 5.75 7.875 .73 

12/78 7.75 9.00 .86 

3/79 8.90 9.375 . 95 

6/79 8.875 9.50 .93 

9/79 9.125 10.25 .89 

12/79 10.75 12.875 .83 

1/80 10.75 12.875 .83 

2/80 10.75 14.00 .77 

3/80 12.125 16.00 .76 

4/80 13.375 17.00 .79 

Source: Banco Popular de Puerto Rico. Rates in other banks 

usually differ by no more than 1/8 or 1/4 of a point. 

There could be a substantial difference if one or more 

banks do not have available eligible assets. Virtually 

the same pattern appears in data provided by the Puerto 

Rican Treasury on the differential between interest on 

936 CD's and U.S. certificates of deposit. 
-98-

Table 26 

936 Deposits and Loans by Commercial Banks 

(Dollars in Millions) 

Total Loans -: 

End of Month 936 Deposits and Discounts _J 

6/77 1,472 4,580 

12/77 1,745 4,661 

6/78 1,839 5,078 

12/78 1,998 4,955 

6/79 2,414 5,425 

12/79 2,878 5,454 

Source: Government Development Bank for Puerto Rico. 

The competitiveness of the 936 deposit market that iS 

reflected in the virtual closing of the differential in earlY 

1979 may have been a temporary phenomenon. The period of the 

narrowing of the differential did coincide with the first year of 

the Bank of America's operaion in Puerto Rico. It quicklY 

acquired almost $200 million in 936 deposits, apparently bY 

bidding agressively, i.e., offering a premium for them. Competitive pressures may have abated because its deposits did not rise 

much after August 1979. Still, we noted above that there are 

other signs of increased competition. Banco Popular, the largest 

local bank, started to bid aggressively for deposits in the 

latter part of 1979 and almost doubled its total of $185 million 

at year end 1978. The Canadian banks are also becoming more 

significant. The increase in 936 deposits relative to loans, and 

not reduced competiveness, explains the widening differential in 

1979. If there should again be a substantial increase in 

"eligible" loans while 936 deposits remain unchanged, active 

bidding for deposits can be expected. Further, the nature of 9~6 

deposits is conducive to competitive behavior. Each deposit is 

very large and it is therefore very profitable to seek out the 

best rate. The market for 936 deposits is therefore quite 

different from the market for loans, where borrowers are verY 

heterogeneous and may require intensive credit analysis, or have 

long-term banking relationships that they are reluctant to 

disrupt. 

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-99-

2. The old regulations governing the use of 936 funds 

seem to have imposed some real constraints. In other words, 

despite the opportunities that apparently existed before April 1, 

1980, for circumventing the rules on the use of 936 funds, the 

restrictions did have some bite. The reason for this conclusion 

is that it would otherwise be difficult to explain the 

substantial widening . of the differential after it had virtually 

dissappeared in early 1979. We have concluded that there was no 

overall reduction in the competitivenss of the market for 936 

deposits. If anything, in 1979 the market probably became more 

competitive as the number of banks that could effectively bid for 

deposits increased. However, when the total 936 deposits grew 

much faster than loans in 1979, the differential between 936 and 

non-936 deposits widened substantially. If banks had felt no 

constraints in the use of 936 funds, they presumably would have 

continued to be willing to pay a high price for them. The 

Widening of the differential therefore suggests that their 

inability to find an adequate volume of "eligible" loans 

restricted their profitable ~ses of the 936 deposits. 
-100-

E. The Market for Loans in Puerto Rico: How Much do 

Borrowers Benefit from Low-Cost 936 Funds? 

We have seen in earlier sections that 936 deposits are 

frequently much cheaper sources of funds than regular certificates of deposits. 11/ How does the availability of this large 

pool of relatively inexpensive deposits affect interest rates 

charged to borrowers? In an earlier Section it appeared that the 

inflow of 936 funds did not lead to an appreciable increase in 

bank lending. Information on borrowing costs would add further 

clues to the impact of 936 funds on investment in Puerto Rico. 

If banks lower the interest rates charged to borrowers, there is 

more likely to have been an expansion in Puerto Rican investment 

due to the presence of 936 funds. It may be that banks do not 

lower their lending rates but are more willing to extend loans. 

Still, one would expect an adjustment in both directions, in 

lower interest charges and more loans. Furthermore, the extent 

to which banks lower interest rates is interesting even if it 

doesn't increase investment demand because it will indicate how 

the benefits of 936 funds are distributed among various economic 

groups in Puerto Rico. 

Direct information on bank spreads is unfortunately difficult 

to obtain. It is necessary to rely on the views of experienced 

participants in the Puerto Rican capital market. Some bankers 

stated that they were passing through the lower costs of funds 

fully. Others conceded that they benefited from the opportunitY 

for larger spreads provided by 936 funds. (Both could, of course, 

be right.) One phenomenon that was frequently alluded to was 

"match funding" of 936 deposits with loans of the same maturitY 

extended to large multinationals, with the interest rates based 

on the 936 CD rate. Apparently the multinationals are able to 

get lower cost loans because of their willingness to accept short 

terms and, consequently, the prospect of having to repay after 90 

days if there is a withdrawal of 936 deposits. They are in a 

position to repay the loans if necessary because they can fall 

back on their ability to borrow from U.S. banks. That is, theY 

have access to the U.S. capital market. However, this increases 

the likelihood that the loan by a Puerto Rican bank simplY 

replaces a loan from a stateside bank. The low cost funds in 

Puerto Rico may not encourage more investment there because the 

multinational would be reluctant to invest in projects with a iow 

rate of return in Puerto Rico when it has better opportunities 

.!.!./ If a bank has a large retail operation, it may have substan~ 

tial low-cost demand and savings deposits which are cheaper 

than 936 money. On the other hand this may involve large 

investments in facilities and processing costs. 

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-101-

elsewhere. It would attempt, where feasible, to arrange 

financial flows among its affiliates to increase investment where 

the return is highest. 

Investment bankers were also not entirely consistent in their 

re views. One leading investment banker said that he knew of many 

:s cases in which local:. borrowers got lower cost funds. Another 

e investment banker stated that of more than a hundred cases which 

n he knew about, banks offered lower terms in only a single 

r instance. This difference in perceptions was perhaps due to the 

fact that the first investment banker's experience was based on 

s the larger local companies. 

t 

t Attorneys and accountants who specialized in 936 companies 

seemed the most skeptical that 936 funds were changing investment 

n Patterns. One leading specialist in 936 expressed the view that 

t borrowers received better terms only if they had first linked up 

t With prospective 936 depositprs and brought the deal to the bank. 

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The pattern that emerges is that there is a wide range of 

types of borrowers with differing abilities to negotiate lower 

borrowing costs. Each borrower has some bargaining power in that 

he can threaten to take his business elsewhere and deprive the 

bank of an "eligible" asset. Since we have seen that even under 

the pre-April 1, 1980 rules, a bank's ability to acquire 936 

deposits was somewhat constrained by the amount of eligible 

loans, a loss of an eligible asset would be costly to the bank. 

However, the credibility of the threat to go to another bank will 

Vary a great deal. At one extreme are large multinational 

companies with well known credit standings who are able to 

negotiate with several banks having 936 funds. They apparently 

9et substantial reductions in interest costs. At the other 

extreme are small Puerto Rican firms having long-term banking 

~~lationships with only one or two banks which they, the Puerto 

lean firms, don't want to jeopardize. A new bank would require 

an extensive credit analysis before extending a loan. Also, the 

cal firm's only effective alternative may be one of the smaller 

domestic banks which don't have many 936 deposits and therefore 

bon•t have "cheap" money to offer. This kind of small local 

torrower, therefore, finds it difficult to negotiate better 

erms. The larger Puerto Rican firms are somewhere between these 

~Xtremes. Some of them seem to be getting lower cost funds, but 

it is difficult to know how many. 

1 There does appear to be increasing competitiveness in the 

e~an. market. The "back to back" kind of loans referred to . rl1er seem to be a growing phenomenon. In 1978, a leading 

investment banker started to arrange these deals in which he 
-102-

links a 936 depositor with a Puerto Rican borrower. They then 

approach a bank. Another leading investment banking house has 

also entered into the business of arranging similar matches. The 

banks are understandably disturbed by the prospect of borrowers 

and depositors knowing each other, but some seem to be willing to 

agree to the arrangement. The total volume of these kinds of 

"back to back" deals may now amount to almost $500 million. In 

most cases the borrowers are "eligible" but not exempt firms so 

that a bank is required as an intermediary according to the 

Puerto Rican rules. However, the banks provide other 

intermediary services as well, including credit analysis and 

willingness to put their capital at risk. 

It should also be noted that the operation of the 

"incremental" rules makes it difficult for the banks to be verY 

mechanical in offering lower terms to borrowers. Banks can only 

use 936 deposits to finance loans in excess of the base level on 

April 30, 1975. However, if new borrowers get lower interest 

rates, those in the base may insist on them as well. The "old" 

loans may in fact threaten to go to another bank where they would 

be "incremental" loans. Borrowers will therefore sort themselves 

out in some sort of equl ibr ium in which large borrowers with 

several alternative sources of financing will probably benefit 

most irrespective of whether or not they are in the base. It is 

of some interest that one of the banks which gets high marks from 

many observers for its pass-through of lower interest costs, the 

Bank of America, operates almost exclusively with 936 funds and 

has no base problem because the branch was established in 1978. 1JI 

g; The rules will probably mean that bad debts in the base are 

never written off because doing so would reduce the amount of 

loans that are considered incremental. One attorney is of 

the opinion that write-offs for tax purposes don't require 

them for 936 purposes. 

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-103-

F. The Puerto Rico Government and the Mortgage Market as 

Beneficiaries of 936 Funds 

1. Commonwealth of Puerto Rico Obligations 

In an earlier Section on the balance of payments, we saw that 

the introduction of section 936 led to a shift in the ownership 

of Puerto Rican government obligations. The analysis of bank 

portfolios revealed an increase in their holdings of Puerto Rican 

Government obligations of more than $400 million between June 30, 

1975 and December 31, 1979. Possessions corporations have also 

made some direct purchases of Commonwealth of Puerto Rico 

obligations. 

This increased demand for Commonwealth of Puerto Rico 

obligations does not, however, appear to have resulted in a 

significant . reduction in net interest costs on public issues. 

Table 27 gives net interest ,costs for public offerings from 1975 

through early May 1980. Column 4 is the Bond Buyer's index of 

interest yields on tax-free municipals. There seems to have been 

a moderate decline in the differential between net interest costs 

on Puerto Rican issues and the Bond Buyer index. The differential in the five latest issues was about • 50 percentage points 

lower than in 1975 or 1976. This may, however, have been due 

largely to the widespread perception of Puerto Rico's improved 

financial management and to the much slower growth in Puerto 

Rican public debt in fiscal years 1978 and 1979. 

. The reason for this small, if any, effect on interest rates 

is that most of the Puerto Rican government debt is still held in 

the United States. It, therefore, has to compete in yield with 

Other tax-free obligations. Section 936 increased the Puerto R~can demand for Puerto Rican government debt by perhaps one 

billion dollars. This compares with a gross stock outstanding on ~une 30, 1979, of $6.4 billion. The data on the foreign 

investment position of Puerto Rico provided by the Puerto Rican 

Planning Board indicate that more that $5 billion of government 

debt was held abroad, presumably in the United States. Because 

Puerto Rican issues are a relatively small percentage of the 

total tax-free U.S. market, interest costs will depend primarily 

on the perceived risk of default and will not be much affected by 

a small shift in the amount available to U.S. investors. _!l/ 

.!l! The Puerto Rican press and government have emphasized this 

importance of mainland investors and of the Puerto Rican 

budget deficit in determining the success of a bond issue. 

The $300 million issue in May 1980 at favorable rates was 

reported as a reflection of the appeal of Puerto Rican bonds 

to mainland investors. Furthermore, the President of the 

Government Development Bank stated that the narrowing 

interest differential since mid-1977 "speaks very well of the 

success that Governor Romero has had in putting our financial 

house in order." 
-104-

Table 27 

Interest Costs on Bond Issues Sold * 

1975 - 1979 

(1) (2) ( 3) ( 4) 

Net Bond 

Agency Amount Date Interest Buyer (Col. 3 -- Cost Index Col-4) 

1975 Commonwealth of P.R. 80,000,000 1-29-75 8.00 6.54 1.46 

PR Urban Research & Housing Corp. 67,000,000 2-26-75 7.98 6.40 1. 58 

PR Telephone Authority 75,000,000 4-17-75 9.13 6.86 2.27 

Commonwealth of PR 75,000,000 5-22-75 9.00 7.09 1. 91 

PR Highway Authority 50,000,000 

PR Water Resources 50,000,000 11-13-75 9.92 7.43 2.49 

1976 PR Highway Authority 35,000,000 2-27-76 9.96 6.98 2.98 

PR Telephone Authority 50,000,000 5-13-76 8.99 6.71 2.28 

University of Puerto Rico 22,650,000 8-18-76 9.15 6.60 2.55 

PR Water Resources 60,000,000 10-13-76 8.23 6.33 1. 90 

PR Aqueduct & Sewer 35,000,000 12-10-76 7.88 5.96 1. 92 

1977 PR Highway Authority 62,500,000 2-18-77 7.61 5.86 1. 75 

Commonwealth of Puerto Rico 300,000,000 4-14-77 7.89 5.70 2.19 

PR Highway Authority 75,000,000 8-10-77 6.99 5.63 1. 36 

Puerto Rico Ports 29,500,000 11-17-77 7.33 5.45 1.88 

1978 PR Public Buildings 110,000,000 2-14-78 7. 72 5.61 2 .11 

PR Industrial Dev. Co. 40,000,000 3-31-78 7.98 5.69 2.29 

PR Telephone Authority 100,000,000 6-29-78 7.99 6.31 1. 68 

PR Water Resources 125,000,000 9-26-78 7.70 6.12 1. 58 

PR Telephone Authority 25,000,000 11-15-78 7.56 6 .11 1. 45 

Commonwealth of Puerto Rico 100,000,000 11-17-78 7.98 6 .11 1.87 

1979 PR Public Buildings 125,000,000 4-05-79 7.90 6.28 1. 62 

PR Telephone Authority 110,000,000 6-06-79 7.56 6.09 1. 47 

PR Water Resources Authority 100,000,000 10-18-79 9.07 7.18 1. 89 

PR Telephone Authority 50,000,000 1-24-80 8.95 7.33 1. 62 

l9SO Commonwealth of Puerto Rico 300,000,000 5-7-80 9.37 7.96 1. 41 

* ~~~ in~o~Thation p~ovide by Gove~nment Development Bank for Puerto Rico 

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-105-

There may have been larger interest savings on direct loans 

by banks to government agencies. Deposits by banks in the 

Government Development Bank have grown substantially since 1975 

and are expected to grow by a further $50 million because of the 

new regulations. The interest paid on these deposits is the 

after-(corporate) tax Eurodollar rate, which is less than banks 

pay for 936 CD's and on average may be less than the market rate 

on Puerto Rican public issues. 

Another important vehicle for direct bank financing of the 

Puerto Rico government is the Note Purchase Agreement. This was 

entered into on December 28, 1978, by the Government Development 

Bank and nine designated government corporations, on the one 

hand, and six major mainland banks and six Puerto Rican banks on 

the other. Under the Agreement, the banks have both a term 

commitment and a revolving commitment to purchase notes issued by 

the designated coporations to the Government Development Bank. A 

total of about $300 million of debt was outstanding under the 

Agreement on December 31, 1979. 

How has the Puerto Rican government used the proceeds from 

its loans? In particular, is arbitrage one of the uses? The Gov~rnment Development Bank did have investments of $476 million 

in U.S. money markets on June 30, 1979. However, this was 

apparently only temporary and due to the anticipation of large 

Withdrawals by government agencies. The money market investments 

decreased to $120 million on December 31, 1979. It is difficult 

to tell whether the GDB's role as fiscal agent justifies its 

Volume of money market investments. These investments do seem to 

have risen in recent years. 

2. GNMA's -- Mortgage-Backed Securities Guaranteed by the 

U.S. Government 

GNMA's are securities issued by mortgage lenders which are 

backed by a pool of mortgages and whose interest and principal 

~re guaranteed by the U.S. Government. The mortgages in the pool 

ave to be government-insured. The securities are issued with a 

coupon SO basis points (.5 percentage points) below the FHA 

mortgage rate. The price of any GNMA at issue depends on market 

tates and the special features of any particular pool, e.g. some 

~ay have a faster rate of principal repayments. 

GNMA's backed by Puerto Rican mortgages are different from 

1ebt of the Commonwealth in that they are very desirable 

9nvestments for 936's and their supply is small compared to total 

p36 funds. GNMA's are more desirable than the government of 

Uerto Rico debt because, before 936, they carried a high yield 
-106-

similar to other taxable (in the U.S.) issues. The principal demand had been by U.S. investors. When the introduction of 

section 936 ended the tax exemption for 936 investments in the 

Eurodollar market, GNMA's became one of the few high-yield 

investments that were still tax-exempt. Not surprisingly, the 

936's bought up virtually all the available stock. On March 31, 

1980, total outstanding GNMA issues orginating in Puerto Rico 

amounted to $1.20 billion dollars. As a result of the 936 

demand, and their limited supply, Puerto Rican GNMA's now sell at 

a substantially higher price than U.S. GNMA's with with same 

coupon. For example, in April 1980, when U.S. GNMA's with a 12.5 

percent coupon were selling at 85, Puerto Rican GNMA's with the 

same coupon were selling at par. The interest yield on US GNMA'S 

was more than 2 percentage points higher. In June 1980, GNMA's 

with an 11 percent coupon were selling at par if they were U.S. 

source and at 106.5 if Puerto Rican. This implies a yield 

differential of about one percentage point. 

This substantially 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 saving 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 rates on conventional mortgages do not seem signif icantly lower than in the U.S. According to the Government 

Development Bank, the rate on conventional mortgages in the 

middle of June 1980, was 12.5 percent plus a one-time fee of 3 

percent, which implies an annual interest cost only about 1/4 of 

1 percent lower than in the U.S. 

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 1979. In the years immediatelY 

following the introduction of section 936, GNMA issues were as 

high as $250 million per year. In the 1979 depressed housing 

market of 1979, they amounted to only about $100 million. 

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-107-

G. The Volume of 936 Funds in Puerto Rico: Can they be 

Absorbed? 

As indicated in Table 18-A at the beginning of this Chapter, 

financial investments in Puerto Rico by exempt 936's amounted to 

approximately $4. 6 billion at the end of 1979. Approximately 

$2.9 billion was in CD's in Puerto Rican banks. Another one 

billion dollars was probably in Puerto Rican source GNMA's out of 

a total stock outstanding of $1.2 billion. Direct loans to other 

exempt corporations, purchases of capital notes of Puerto Rican 

banks, bonds of the Commonwealth of Puerto Rico, and bonds issued 

by schools and hospitals may have equaled another $700 million. 

The approximately $5 billion in 936 funds that have flowed 

into Puerto Rico is an enormous amount for Puerto Rico to absorb. 

The gross national product of Puerto Rico was $10 billion in the 

Year ending June 30, 1979. Annual gross domestic investment, 

including new plant, equipment, and housing construction, both 

Private and government, was equal to $1.9 billion, which is about 

What it had been in each of the prior 4 years. The absorption of 

~he $5 billion in 936 funds in the less than five years since the 

institution of section 936 would therefore have required an 

increase in gross investment of more than 50 percent per year. 

It is conceivable that investment in Puerto Rico could have 

increased by this much, but it would have required a very sharp 

drop in the cost of capital to bring it about. It is difficult 

to be very specific about the decrease in the cost of capital 

~hat would have been necessary because the elasticity of 

investment with respect to the cost of capital is one of the more 

controversial areas of economic analysis. However, it is 

Possible to get an idea of the magnitude by using a report 

tecently prepared for the U.S. Treasury. 14/ The report simulated 

the effect on u. s. investment of various tax changes using six 

~eading econometric models. These tax changes affect investment 

Y.changing the cost of capital, which is the annualized cost of 

Using capital and reflects acquisition costs, interest ·costs, 

~epreciation, and any tax credits or charges. In the simulation 

in Which investment is most responsive to a change in the cost of 

~apital, a reduction of the cost of capital of 10 percent 

induced, with a lag, an increase in annual investment of 15 

Percent. If the economic relationship held in Puerto Rico, a 50 

Pef rcent expansion in investment would require a fall in the cost 

0 c . ap1tal of more than 30 percent. 

------------~~~~ !..11 Robert s. Chirinko and Robert Eisner, The Effect of Tax 

~~~~m~!~£~-~~,.l~~~~~m~~!_Eg~~!ion~_£!_~~£££~£onom~c _conometr1c Moae~s, Prei1m1nary Draft, May 1980. 
-108-

The cost of capital is basically made up of two components. 

One is the interest paid on the investment. The other is 

economic depreciation reflecting the declining value over time of 

the capital. In order for the overall cost of capital to fall by 

30 percent, the interest component has to fall by a larger 

percentage because the depreciation component remains constant. a 

In other words, a fall in interest costs of 40-50 percent is s 

required, under the most optimistic assumptions, in order to t 

increase investment by 50 percent. i 

t 

A fall of interest costs of this magnitude would create very a 

large opportunities for arbitrage between the low-cost Puerto b 

Rico market and the U.S. or Eurodollar market. The ability to q 

arbitrage varies among the various economic groups. It is verY t 

inexpensive for banks but their activities are, at least in part, 

restricted by the Puerto Rican Treasury regulations. Borrowers ] 

from a Puerto Rico bank can also arbitrage if they get low-cost 

funds, but it is more expensive for them because of the bank's 

spread on its cost of funds. A drop in interest costs of 40 to 

50 percent would, however, certainly make arbitrage profitable 

even after paying the bank's spread. It is, therefore, apparent 

that interests rates would . not fall enough to induce full 

absorption of 936 funds in Puerto Rico because arbitrage to the 

U.S. market would intervene. 

Much of the absorption problem was of course due to the 

sudden influx of $3 billion or more in a short time after 936 was 

passed. Furthermore, the problem was recognized by the Puerto 

Rican authorities and was reflected in the warehousin9 

opportunities that existed until April 1, 1980. The annual 

increase in 936 funds may, however, continue to be substantial, 

at least in some years. For example, 936 deposits in Puerto 

Rican banks increased by $900 million from year-end 1978 to yearend 1979. 
-109-

:> • 

Ls H. The Effect of the New Puerto Rico Regulations, Effective 

>f April 1, 1980 

.S 

:o 

y 

0 

0 

y 

s 

The new Puerto Rico regulations, effective April 1, 1980, 

appear to constrain the banks' use of 936 funds much more 

severely. Under the new regulations the banks will only be able 

to take in 936 deposits if they have eligible assets to put them 

in. It appears that the end of warehousing opportunities will be 

the most significant change. Table 24 above indicates that repos 

amounted to about 6 percent of total 936 funds in commercial 

banks in April 1980. Also, compliance based on end of the month 

deposits apparently did not lead to much distortion because the 

totals in Table 24, which are based on average daily balances, 

are only slightly higher than the total reported on December 31, 

1979. 

The effect of the new regulations will depend on the rate of 

new inflow of 936 deposits' compared to regular funds because 

banks appeared in May 1980 to have an approximate balance between 

eligible assets and 936 deposits. They reported an increase in 

eligible assets since May 1, 1975 of $3.4 billion, which is very 

Close to their 936 funds including repos. One reason for this 

~alance is banks' ability to report assets acquired from 

insolvent banks in the incremental category. If inflows of 936 

deposits in 1980 equal the $900 million in 1979, the new 

regulations will probably restrict banks freedom to use the 

funas. On the other hand, if there is a modest growth in 936 

deposits, the "normal" growth in eligible assets would be 

Sufficient for compliance. 

If there is an inflow of 936 funds larger than the "normal" 

9rowth in eligible assets, one result will be that banks will 

teauce their demand for 936 funds. This will have the effect of 

driving down the interest rate on 936 CD's compared to regular 

CD•s. The closer match between deposits and eligible assets 

~anaated in the new regulation will also have the effect of 

l~creasing eligible assets, including loans. An eligible asset 

11 now be more valuable in enabling a bank to bid for deposits. 

In owever, it is impossible to predict to what extent the closer 

~~tch is accomplished by reducing the demand for 936 funds and to 

at extent it is achieved by increasing eligible assets. In 

f:it this depends on the response of 936 corporations to lower 

i Urns on their deposits. If they don't reduce them by 

e~crea~ing repatriation or shifting to the Eurodollar market, an 

Pans1on of bank loans is more likely. 
-110-

The effect on bank profitability is also uncertain. Banks p. 

may make a somewhat higher spread on eligible bank loans. we 

have seen that the cost of 936 deposits will probably go down. 

In the section on the interest charged by banks for loans, it 

appreared that while many borrowers appeared to benefit from low 

cost funds the pass through by banks of the discount in 936 

interest rates was not complete. Many borrowers pay interest 

rates based on "high cost" money. A reduction in the interest 

cost to banks of 936 funds compared to regular money market rates 

may therefore increase the spread on loans. On the other hand, 

there may be pressure to lower the spread in order to obtain more 

eligible assets. Furthermore, banks will be hurt by the reduced 

opportunities for warehousing and the resulting profits from 

arbitrage. 

The smaller local banks would appear to benefit from the new 

regulations. Since the "upper tier" banks will find their 

ability to attract 936 deposits restricted, more 936 funds maY 

flow to the smaller banks which ordinarily have an excess of 

eligible assets. However there are some signs that the national 

banks will reduce their redeposits of 936 funds in the smaller 

local banks. The reason for this is not clear. 

The new regulations may also have some effect on decisions bY 

prospective 936 corporations to invest in Puerto Rico. Some maY 

be discouraged by the reduced return on their financial 

investments although others who need capital may be attracted bY 

the availability of cheap funds. 

One factor that has colored the financial behavior of 936 

companies in the past few years is regulatory uncertainty. At 

first, 936 corporations hoped that the tollgate tax would be 

removed. This has not happened but there have been a number of 

changes. Because of this uncertainty over the rules for 

repatriating income, 936's have been unwilling to commit 

themselves to long-term financial investments in Puerto Rico· 

The rules on the various ways of achieving lower tollgate taxes 

have also been very complex. As 936's get more experience witb 

them, their financial planning may be more long term in nature. 
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-111-

Appendix A -- Operatiqn of the Possessions Corporation 

SEstern of Taxation in American Samoa, Guam, 

t e Panama Canal Zone, and the Virgin Islands 

The term "possession" as used in sect ion 93 6 of the 

Internal Revenue Code includes not only Pu er to Rico, but 

also Arner ican Samoa, Guam, the Panama Canal Zone (before 

October 1, 1979), and other smaller U.S. territories. 1/ It 

does not include the Virgin Islands. u. s. corporations 

operating in American Samoa, Guam and the Canal Zone qualify 

for special tax treatment under section 936 in the same 

manner as U.S. corporations operating in Puerto Rico. As in 

the case of 936 companies in Puerto Rico, the Federal tax 

expenditure associated with section 936 and related provisions depends upon the amount of income tax paid- by each 936 

company to the host possession. The loss of revenue to the 

Federal Treasury is the amount of U.S. tax liability on each 

company's qualified possession source net income in the 

absence of either a foreign tax credit or section 936, less 

the tax payments to the host possession. 

The first Section of this Appendix describes the income 

tax law and tax-incentive programs of American Samoa, Guam 

and the Panama Canal Zone. It is estimated that the average 

effective rate of tax paid by 936 corporations was 10 percent on income derived from Guam and zero percent on income 

derived from Arner ican Samoa and the Canal Zone. The combined Federal tax expenditure for all three possessions was 

approximately $1.9 million in tax year 1978. 

The second Section of the Append ix compares the tax 

treatment accorded to 936 companies with that accorded to 

corporations operating in the Virgin Islands. Corporations 

Which are "inhabitants" of the Virgin Islands are exempt 

from U.S. tax under section 28(a) of the Revised Organic Act 

of the Virgin Islands. In 1978, the income tax expenditure ~ssociated with section 28 (a) and the Virgin Islands tax1ncentive program was $18.6 million, of which $16.4 million 

Was attributable to u. S .-controlled corporations. Firms 

Which have Virgin Islands tax incentive grants benefit, as 

Well, from exemption from property, customs, excise, and 

9ross receipts tax. The V.I. gross receipts tax expenditure 

!/ Other territories to which section 936 benefits apply 

are the Northern Mariana Islands and Wake and Midway 

Islands. As of 1978, no 936 corporations were operating 

in these territories. 
-112-

in 197 8 was approx irna tely $5 7 mil 1 ion. The $ 5 7 mil 1 ion 

figure was computed by multiplying the business receipts of Arn ~ 

all tax-exempt firms in the Virgin Islands by 2 percent, the re 

rate of the gross receipts tax. Available data do not irn 

permit the estimation of the taxes foregone under other Arn 

local V.I. taxes. ex 

I. American Samoa, Guam and the Panama Canal zone 

A. Federal and Possessions Taxation 

Arner ican Samoa and Guam, 1 ike Pu er to Rico, constitute 

income tax jurisdictions separate and distinct from that of 

the United States. Arner ican Samoa and Guam have pr irnary 

jurisdiction to tax u. S. corporations operating there, and 

the United States has secondary jurisdiction. 

The income tax laws in effect in American Samoa and Guam 

are a "mirror image" of those in force in the United States. 

This means that the U.S. Internal Revenue Code is applied as 

a local territorial tax code, with the name "Arner ican Samoa" 

or "Guam" substituted for the name "United States" wherever 

it appears in the U.S. Code. In Arner ican Samoa, the "mirror 

system" was enacted by the local legislature in the American 

Samoa Income Tax Act, effective January 1, 1963. In Guam, 

the "mirror system" was provided for by section 31 of the 

Federal Organic Act of Guam (48 U.S.C. 142l(i)), effective 

January 1, 1951. Under this section, 

"The income tax 1 aws in force in the United 

States of America and those which may hereafter be 

enacted shall be held to be 1 ikewise in force in 

Guam." 

Unlike Puerto Rico, Guam does not impose a withholding 

tax on dividends paid from Guam-source income to U.S. parent 

companies. Special provisions 2/ of the "mirrored" Internal 

Revenue Code, enacted by Congress in 1973, exempt a u.s. 

parent corporation from tax on dividends and other passive 

income derived from Guam. Under section 935 ( c) of the 

"mirrored" Internal Rev~nue Code, a U.S. individual iS 

similarly exempt from tax on payments derived from Guam. 

£/ Internal Revenue Code sections 88l(b) and 1442(c). 

or 

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-113-

No Federal provision explicitly limits the authority of 

American Samoa or Guam to provide income tax relief with 

respect to possession source income. Under the taxincentive program of American Samoa, the government of 

American Samoa grants to qualifying corporations temporary 

exemptions from the payment of some or all income taxes. In 

order to qualify, the corporation must be owned by a resident of American Samoa and employ a work force at least 75 

Percent of which consists of American Samoan residents. The 

Period of tax exemption is for up to 10 years, although it 

may be made to terminate earlier if the cumulative amount of 

income taxes forgiven equals 100 percent of the net current 

investment in American Samoa. 

The Guam Economic Development Authority grants rebates 

Of up to 100 percent of Guam income taxes to corporations 

that meet minimum investment and certain other requirements (such as increasing employment, replacing imports, or 

creating vitally needed facilities). The rebate is allowed 

for up to 20 years. 

As of 1978, all 936 corporations operating in Guam 

received a rebate of 75 percent of Guam income taxes. Given 

the 936 forgiveness of their U.S. tax liability, these corPorations paid an average effective tax rate of 10 percent 

0 n income from the active conduct of a trade or business in ~uam and on passive income derived from the reinvestment of 

l.ncome from the trade or business. 3/ Many of these corPorations enjoyed, in addition, exemption from the Guam real 

Property tax. In the case of a few tax-exempt corporations, 

the individual shareholders were granted rebates of 75 

Percent of the income tax on any dividends received. 

~./ A 1 9 7 8 study by the Depa r tm en t o f the Tr ea s u r y , 

~!!~£tl~~-In£E~~-Ta~_Ra!~2_Pa1~-b~_Unit~d_St~t~~ 

Corporations in 1972, found that the average effective 

income tax rate was 4 0 percent, compared to a maximum 

statutory corporation income tax rate of 48 percent. 

For 1979 and all subsequent years, the effective Federal 

corporate tax rate is assumed to fall from 40 percent to 

38 percent to reflect the statutory U.S. corporate tax 

rate reduction of two percentage points. 
-114-

The Panama Canal Zone imposed no local territorial 

income tax. Prior to October 1, 1979, 4/ a Federal agency 

(the Panama Canal Company), administered-the Canal Zone and 

financed its 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 

Table A-1 shows that in 1978, there were four active 936 

corporations in American Samoa and Guam. These corporations 

had qualified possession net income of $858,000. Under 

sec ti on 9 3 6 , they obtained tax s av i ng s o f $ 2 5 7 , 0 0 0 • The se 

figures compare with 1977 qualified possession net income in 

excess of $2 million and tax savings of $1.1 million for 

four 936 corporations. 

There were seven 936 corporations operating in the 

Panama Canal Zone in 1978. They had qualified possession 

net income of $4.1 million and accounted for a Federal 

revenue loss of $1.6 million under section 936. These 

figures compare with 1977 qualified possession net income of 

nearly $3 million and tax savings of $1.1 million for five 

936 corporations. 

II. Virgin Islands 

A. Federal and Virgin Islands Taxation 

The Virgin Islands are 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. Under section 28(a) of the 

Revised Organic Act of the Virgin Islands, "inhabitants" ~f 

the Virgin Islands are taxed on their worldwide income by 

the Virgin Islands and are exempt from any income tax 

liability to the FedeiarTreasury, even on their U.S.-source 

!/ Pursuant to the Panama Canal Treaties of 1977, the 

United States ceased to have jurisdiction over the Canal 

Zone on October 1, 1979. On that date, the Canal zone 

also ceased to be a possession for purposes of section 

93 6. 
-r1sTable A-1 

Income and Estimated Tax Expenditure 

by Possession, 1978 

Number 

of 936 Possession ....._ ~Corporations~ 

l\iner ican Samoa and Guam 4 

~anama Canal Zone 7 

Total 11 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

Qualified 

Possession 

Net Income 

($000) 

858 

4,115 

4,973 

Estimated 

Tax Expenditure 

($000) 

257 

1,646 

1,903 
-11~-

income. All corporations chartered in the Virgin Islands 

are considered to be "inhabitants" of the Virgin Islands. 

In Revenue Ruling 80-40, published on February 19, 1980, the 

Internal Revenue Service ruled that a United States corporation may al so under certain circumstances qualify as an 

"inhabitant" of the Virgin Islands within the meaning of 

section 28(a). 

Before the I.R.S. issued this ruling, it was unclear 

whether U.S. corporations could qualify as V.I. 

"inhabitants." Thus, U.S. parent companies operating a 

trade or business in the Virgin Islands normally did so 

through V.I.-chartered subsidiaries. 

The income tax laws in effect in the Virgin Islands are 

a "mirror image" of those in force in the United States. 

The U.S. Internal Revenue Code is applied as a local territorial tax code, with the name "Virgin Islands" substituted 

for the name "United States" wherever it appears in the U.S. 

Code. The "mirror system" was provided for under the 

Federal Naval Appropriations Act of 1921 (48 u.s.c. 1397). 

Effective for taxable years beginning in 1960, section 

934 of the Federal Internal Revenue Code limits the power of 

the Virgin Islands government to grant relief from its 

income tax. This section prevents the Virgin Islands from 

granting rebates for taxes attributable to income derived 

from sources within the United States. With respect to 

non-u.s. source income, section 934 limits the Virgin 

Islands' authority to grant corporate tax rebates to U.S. 

and V. I. corporations which meet the so-called "80-50 

tests," used al so in sect ion 93 6. That is, to qualify for 

V.I. tax rebates under section 934, a corporation must have 

derived for the past three taxable years (or applicable part 

thereof) 80 percent of its gross income from V. I. sources 

and at least 50 percent of its gross income from the active 

conduct of a trade or business within the Virgin Islands. 

The Virgin Islands Industrial Development Program 

provides rebates to certain U.S. and V.I. corporations of 90 

percent of the V.I. income tax attributable to income 

derived from the Virgin Islands. ~/ In order to 

~/ These rebates do not apply, however, to Virgin Islands 

tax on interest income, capital gains, and certain types 

of rental income. 
-117-

qua 1 if y for these rebates , a corporation must meet the 

requirements of section 934 and certain other requirements. 

The principal requirements are that it: 

(1) invest at least $50,000, exclusive of inventory, in a Virgin Islands industry or business; 

(2) agree in writing to give preference in employment and contracting to Virgin Islands 

residents and V.I. corporations; 

(3) obtain approval from the Commissioner of Labor 

for any nonresident workers prior to a grant of 

permission to hire such persons; 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 V.I. 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. 

Industrial Development Program generally receive rebates of 

75 percent of corporate 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. Any particular package of benefits is negotiated between the applicant and the V.I. 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 

ta~ benefits commence, provided they are initiated at some 

Point during the first five years of operating of the business. An additional five years of benefits (or up to 10 

Years at no more than 50 percent of the benefits) are 
-118-

granted to corporations which locate their business in 

certain economically depressed areas. Moreover, any beneficiary under the Industrial Development Program may be 

granted a renewal of those benefits subject to the 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 and the Industrial 

Development Program for a 10-year subsidy of 75 percent of 

income taxes, pays an average effective corporate income tax 

rate in the Virgin Islands of approximately 10 percent. 

A U.S. corporation is treated as a foreign corporation 

for purposes of Virgin Islands taxation. Therefore, it is 

subject to the 30 percent withholding tax on dividends, 

interest, royal ties, and other passive investment income 

which it may receive from a corporation operating in the 

Virgin Isl ands. 6/ Th is tax cannot be forgiven under 

section 934, since the tax is upon the u. s. recipient and 

not upon the company operating in the Virgin Islands. 

However, a 1977 decision of the United States Court of 

Appeals for the Third Circuit 7/ has cast serious doubt on 

the jurisdiction of the Virgin-Islands to withhold tax upon 

payments to U.S. corporations under the "mirrored" Internal 

Revenue Code. If the 30 percent tax is paid, either at 

source or directly by the U.S. recipient, it is creditable 

(subject to limits) against U.S. tax liability. 

Dividends paid by a U.S. subsidiary operating in the 

Virgin Islands qualify for the 85 percent dividends-received 

deduction for purposes of computing the parent company's 

United States tax liability. However, the United States 

does not allow a U.S. parent to take the dividends-received 

§./ 

2/ 

The tax is imposed unless the dividends are paid by a 

v. I. subsidiary which derives less than 20 percent of 

its gross income from V.I. sources or by a U.S.(or other 

foreign) corporation which derives less than 50 percent 

of its gross income from V.I. sources. Neither corporation would qualify for an income tax subsidy by virtue 

of the section 934 eighty and fifty percent source 

requirements. 

Viteo, Inc. vs. Government of the Virgin Islands. 

d 

p 

E 

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-119-

deduction for dividends received from a subsidiary incorporated in the Virgin Islands .. 8/ Thus, even though the 

profits of a qualifying 934 subsidiary may be 75 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. 

There are four principal differences between the tax 

treatment accorded to a U.S. parent corporation of a subsidiary deemed an "inhabitant of the Virgin Islands," and that 

accorded to a U.S. parent of a 936 corporation in Puerto 

Rico. 

(1) Tax on repatriated earnings. Dividends 

paid by a V.I. subsidiary to a U.S. parent corporation are subject to the normal rate of U.S. tax 

upon receipt by the parent. Dividends paid to a 

U.S. parent by a U.S. subsidiary in the Virgin 

Islands are taxable at only 15 percent of the 

normal corporate rate, since they qualify for an 85 

percent dividends-received deduct ion. Div id ends 

paid by a Puerto Rican 936 subsidiary to its U.S. 

parent are not taxable in the United States. (They 

qualify for a 100 percent dividends-received deduction.) Be fore the 197 7 dee is ion in the Vi tco case 

(discussed above), the Virgin Islands imposed a 30 

percent withholding tax on outflows of dividends, 

with no rebates of the withheld tax. Puerto Rico 

imposes a maximum 10 percent tollgate tax on outflows of dividends; special provisions reduce the 

average effective rate of this tax to less than 

five percent. 

~/ This follows from the treatment of V.I. 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 more than 50 

percent of the foreign corporation's income has been 

derived, for the past three years, from a U.S. trade or 

business, and in that case, only with respect to dividends distributed from U.S.-source income. Dividends 

from V.I.-source income would therefore not qualify for 

the deduction. A corporation which met the so-called 

"80-50 source tests" required to be eligible for V. I. 

tax subsidies would not qualify for the deduction even 

with respect to dividends from U.S. source income (Code 

section 245(a)). 
-120-

( 2) Eligibilfu for foreign tax credit. A 

parent with a subsidfarY operatingln the Virgin 

Islands, whether incorporated under U.S. or V. I. 

law, may claim a foreign tax credit for V.I. taxes 

paid with respect to repatriated earnings. A U.S. 

parent of a 936 corporation cannot claim a foreign 

tax credit for tax withheld on repatriated earnings 

or for Puerto Rican taxes on income with respect to 

which the U.S. tax liability is forgiven under 

section 936. 

(3) Consolidation with the U.S.~rent. A 

U.S.-incorporated "inhabitant" of the Virgin 

Islands may be a member of an affiliated group for 

purposes of filing a consolidated return, although 

the law is untested by the courts. A corporation 

which elects the benefits of section 936 cannot 

join with its parent in filing a consolidated return for the 10-year period for which the election 

is made. However, it can delay electing 936 status 

until its operations return a profit. 

(4) Treatment of liquidating distributions. 

In order to avoid the 30 percent withholding tax on 

repatriated V.I.-source earnings, the U.S. parent 

may accumulate earnings in the Virgin Islands and 

then liquidate the subsidiary at the expiration of 

its tax exemption grant. If the liquidating 

subsidiary was incorporated in the United States 

and at least 80 percent owned by a U.S. corporation, gain on the distribution of the subsidiary's 

assets would be exempt from U.S. tax. However, it 

would not be possible for the subsidiary to be 

liquidated free of v. I. tax unless it received a 

ruling from the Virgin Islands that the liquidation 

did not have a tax avoidance purposes. In Puerto 

Rico, liquidating distributions by firms with tax 

exemption grants under the 1978 Industrial 

Incentive Act are subject to the tollgate tax, but 

firms with grants under the 1963 Act may be 

liquidated tax-free. 

It is clear from the above that the incentives to U.S. 

investment in the Virgin Islands which obtain under section 

28(a) of the Revised Organic Act depend significantly on 

whether a U.S. parent corporation can sustain the burden of 

proving that its U.S. subsidiary is an "inhabitant" of the 

Virgin Islands. Assuming that it can, the U.S. parent 

corporation enjoys tax benefits more favor able than those 

enjoyed by a U.S. parent of a 936 corporation and also more 
-121-

favorable than those foreseen by the Congress when it 

enacted section 28 (a) of the Revised Organic Act. The 

parent of the V.I. "inhabitant" would pay no U.S. tax on the 

income of its subsidiary, yet could claim a foreign tax 

credit for any withholding taxes and income taxes paid to 

the Virgin Islands with respect to earnings repatriated to 

the parent. This credit could offset U.S. tax liability on 

income sourced in low-tax countries which had not been fully 

offset by the foreign tax credit for those countries. 

Table A-2 presents estimates of the effective tax rates 

on qualified possession source income which obtain for the 

U.S. parent of three types of corporations a V.I. 

"inhabitant" organized in the Virgin Islands, a V.I. 

"inhabitant" organized in the United States, and a 936 

corporation operating in Puerto Rico. It is based on the 

following assumptions: 

(1) There is full repatriation of the subsidiary's 

earnings to its U.S. parent annually. 

(2) The v. I. "inhabitant" receives a grant of 

income tax exemption from the Virgin Islands 

and elects a 10-year, 75 percent subsidy. 

(3) The 936 corporation in Puerto Rico is completely exempt from the Puerto Rican income tax. 

Dividends paid to the U.S. parent are subjected 

to a five percent Puerto Rican tollgate tax. 

The Table shows that an effective tax rate as high as 46 

Percent may apply to V. I. -source earnings repatriated by a. 

V.r. subsidiary, while an effective tax rate as low as zero 

Percent may apply to V.I.-source earnings repatriated by a 

U.s. subsidiary. This compares to an effective tax rate of 

5 percent on earnings repatriated by a 936 corporation in 

Puerto Rico. 

B. Characteristics of Tax-exempt Corporations in the 

Virgin Islands 

In 1978, there were 54 active firms which were eligible 

for income tax rebates from the Virgin Islands. Table A-3 

Shows selected tax return information as well as the amount 

~ Federal tax expenditure and employment for all tax-exempt 

firms in the Virgin Islands. The employment data were taken 

from Form W-3, "Transmittal of Income and Tax Statements," 

U~ed by V. I. employers to transmit wage and income tax 

Withheld statements to the Virgin Islands Treasury. 
-122-

Table A-2 

Overall Tax Rates on Earnings Repatriated fran the 

Virgin Islands and Puerto Rico 

~~~~~~~~~~~~~~~--.rr.::r--.--..-...,--_,......__. ___ ~~~~~~~--.:~~~----

ii I rifi ab 1tant11 of 936 

U.S. parent able to use 

full V.I. foreign tax 

credit against U.S. tax 

on other foreign source 

income 

U.S. parent limited to 

V.I. credit only 

the Virgin Islands Corporation 

:V.I. subsidiary : U.S. subsidiary:in Puerto Ric~ 

46. 0% .!/ 0.0% 2/ 5.0% y 

46.0% .!/ 33.2% 3/ 5.0% y ._...,...._....~--...--:-.---=--~-:-~~-,.--:-r~~~~~~~~~~~~~~~~~~~~---_-/ Off ice of the secretary of the Treasury 

Off ice of Tax Analysis 

lf Earnings repatriated fran a V.I. (or other foreign) subsidiary are subject 

to the U.S. statutory corporate rate of tax, and a foreign tax credit is 

granted for V.I. taxes paid with respect to such earnings. For tax years beginning before 1979, the statutory rate was 48 percent. 

2/ The net V.I. income tax on, say, $100 of earnings is $11.50 under a systelll 

of 75 percent incane tax rebates. The V.I. tax withheld on repatriated 

dividends is 30 percent of $88.50 or $26.55. The total of V.I. taxes paid 

on this $100 is thus $38.05. The U.S. parent receives an 85 percent 

dividends-received deduction for the dividend, and has U.S. tax liabilitY 

of .46 x (.15) (88.50), or $6.11. This U.S. liability is offset by the 

$38.05 of taxes paid to the Virgin Islands. The excess foreign tax credit 

with respect to V.I.-source incane is used to offset U.S. liability on 

incane fran other foreign sources. This result is possible because it is 

assumed that the U.S. parent has U.S. tax liability on incane sourced in 

low-tax countries which has not been fully offset by the foreign tax 

credit. 

1./ The assumptions here are the same as in the preceding case, except that ~~ U.S. parent does not have U.S. tax liability on foreign source incane wh1c 

has not been fully offset by the foreign tax credit. The total of v.r. 

taxes paid on, say, $100 of V.I.-source earnings is $38.05 (see footnote 

2) • This amount offsets only the U.S. tax liability on this income. 

4/ Firms with Puerto Rican tax exemption grants under the 1963 Industrial 

Incentive Act are typically fully exempt from Puerto Rican income taxes· G· 

The average effective Puerto Rican tollgate tax on dividends paid to a.0· 0 parent is 5 percent. The U.S. tax liability on these earnings is forgive 

under section 936. 
-12)-

1. Type of Corporation 

Of the total of 54 tax-exempt firms which conducted 

operations in the Virgin Islands in 1978, 17 were u.s.-

chartered or U.S.-controlled corporations; 33 were locally 

controlled V.I. corporations; and 4 were foreign-controlled 

V.I. corporations. 

1 2. Total Assets -

,.t 

r 

Total assets of tax-exempt firms were $1.4 billion, of 

which over 95 percent were owned by u.s.-controlled corporations. Net plant and equipment (shown as net depreciable 

assets), represented 34 percent of total assets. 

3. Tax Expenditure 

The total income tax expenditure for all exempt firms in 

the Virgin Islands was $18.6 million and the total gross receipts tax expenditure was $57 million. Locally controlled 

Virgin Islands-chartered corporations accounted for a V. I. 

income tax expenditure of $1.6 million, and a gross receipts 

tax expenditure of $996,000. By comparison, u.s.-controlled 

corporations accounted for an income tax expenditure of 

$16.5 million and a gross receipts tax expenditure of $56 

million. The $16.5 million estimate overstates the U.S. tax 

loss from section 28(a) of the V.I. Revised Organic Act to 

the extent that the U.S.-controlled V.I. subsidiaries 

repatriated their earnings, since such earnings would be 

Subject to the normal U.S. corporate income tax upon receipt 

by the U.S. parents. The $16.4 million estimate also takes 

~o account of the fact that the parent of a u.s.-

lncorporated subsidiary may use V.I. taxes to offset U.S. 

tax liability on other foreign source income, as described 

above. To the extent that this occurs, the $16.4 mill·ion 

figure understates the Federal tax expenditure. 

4. Relationship Between Tax Expenditure and Employment 

The last line of Table A-3 shows that the average income 

tax expenditure per employee of V.I. tax-exempt firms was 

$2,738. This tax expenditure per employee was nearly $4,000 

for u.s.-controlled V.I. firms, compared to $747 for V.I. 

~orporations with no parent firm. The comparable figures 

~r the two U.S. corporations and five V.I. corporations 

: 1 th a foreign parent company (shown in the last column) was .,,1,ou2. 
Table A-3 

Virgin Islands - Selected Income Statement and Balance Sheet Items, 

Tax Expenditure, and Employment by Type of Corporation, 1978 

All v. I. Corporations :v. I. Corporations--

Corporations with a U.S. Parent No Parent 

Number of corporations 54 15 33 

Total assets ($0UU) 1,386,811 1,339,984 44,177 

Inventories (~UOO) 268,080 261,801 4,521 

Depreciable assets ($000) 763,760 738,721 17, 770 

Accumulated depreciation ($000) 253,232 246,939 5,299 

Net depreciable assets ($000) 478,098 459,038 12, 493 

Net intangible assets ($000) 893 677 175 

Total receipts ($000) 2,880,290 2,816,425 50,974 

Business receipts ($000) 2,867,609 2,805,257 49,817 

All other receipts ($000) 12,681 11,168 1,157 

Total deductions ($000) 2,814,478 2,759,371 42, 723 

Cost of sales and operations ($000) 2,628,757 2,585,967 34,806 

All other deductions ($000) 185, 721 173,404 7,917 

Taxable income ($000) 55,386 56,240 926 

Tax expenditure ($UOU) 18,606 16,520 1,589 

Number of employees 6,796 4,173 2,127 

Tax expenditure per employee ($) 2,737 3,959 747 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

: v. I. Corporations 

:with a Foreign Parent 

:& U.S. CorEorations 

6 

12,650 

1,750 

7,288 

994 I 

6,297 ..... 

N 41 .;:. 

I 

12, 891 

12,535 

356 

12,384 

7,984 

4,400 

72 

497 

496 

1,002 
-125-

Table A-4 shows that there was also a wide variation in 

the Federal tax expenditure by industry. The tax expenditure per employee ranged from $12,020 in the chemical 

industry (roughly 120 percent of total compensation of 

employees) to zero in the recreation industry. 

Table A-5 ranks all corporations which have V. I. tax 

exemption grants according to the income tax expenditure per 

employee. At the top of the ranking were three companies 

for which the average tax expenditure per employee was 

$40,UOO. The seven corporations which had a tax expenditure 

per employee of $5,000 or more collectively accounted for 98 

percent of the total income tax expenditure and 38 percent 

o f to ta 1 em p 1 o ym en t • The s e seven f i rm s pa id aver a g e employee compensation of $20,000, substantially higher than 

the average employee compensation of $12,000 for all taxexempt firms in the Virgin Islands. 
Table A-4 

Virgin Islams - Tax Experrliture, Employment arrl canpensation of Employees by Irrlustry, 1978 

Nl.IDber Tax Experrliture Employees Canpensation Tax Experrliture Tax Experrliture Avercge 

of Net Incane of ~lo;tees lL'. 

per employee as a percent Employee 

Corporations Amount Percent Nl.IDber : Percent: hoount Percent of canpensation canpensation 

($000) ($000) :of total: :of total: ($000) : of total: ($) 

All Irrlustr ies 54 55,386 18,606 100.0 6,796 100.0 81,302 100.0 2, 737 22.9 11,962 

Olemicals 4 2,821 1,166 6.3 97 1.4 963 1.2 12,020 121.0 9,932 

watches 16 2,022 807 4.3 1,125 16.6 7,568 9.3 717 10.6 6, 726 

Other manufactur ID3 y 7 41,371 14,635 78.7 2,465 36.3 49,850 61.3 5,937 29.3 20,222 

Transportation 5 -1,485 5 * 391 5.8 3,667 4.5 12 0.6 9,377 

Utilities arrl 

cxmnunication 3 16,155 1,931 10.4 473 7.0 8,875 10.9 4,082 21.8 15,579 

lk>tels 15 -4,590 62 0.3 2,073 30.5 9,492 11. 7 29 0.6 4,579 

Recreation 4 -908 0 0 170 2.5 888 1.1 0 0 5,221 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

*Less than O.us percent. 

y canpensation of employees was canμited by multiplyiD3 1. 221 times payroll. '!he 22.1 percent reflects the employer-paid p:>rtion of social security, 

unemployment insurance, arrl other non-payroll oosts. '!he 22.1 percent is the avercge for all U.S. manufacturirg irrlustries in 1978; see the U.S. 

Department of Carmerce, Survey of Current Business, July 1979, Tables 6.5 arrl 6.6. 

y Inclooes manufacturirg irrlustries where data were available for less than 3 corporations. 

I 

f--1 

....., 

O'I 

I 
Size of Tax Number 

Table A-5 

Virgin Islams - Tax Expemiture, Employment an:i canpensation of Employees by 

Size of Tax Expemiture per Employee, 1978 

Tax Expemiture Employees canpensation Tax Expemiture of ~lol'.:ees lL 

Tax Expemiture Avera;ie 

as a percent Employee Expemiture of Net Incane per employee 

per employee Corporations ($000) .Amol.ll1t Percent tbnber : Percent: .Amol.ll1t Percent ($) of canpensation canpensation 

($000) :of total :of total: ($000) of total of ~lol'.:ees ($) 

All Corporations 54 55,386 18,606 100.0 6,796 100.0 81,302 100.0 2, 737 22.9 ll,962 

$5,000 or more 7 60,002 18,156 97.6 2,582 38.0 50,857 62.6 7,031 35.6 19,696 

$50u Wlder $5,000 5 738 235 1.3 206 3.0 1,882 2.3 1,140 12.4 9,133 

$100 urrler $500 7 656 124 0.7 396 5.8 2,033 2.5 313 6.1 5,133 

$ 1 under $100 6 2,157 91 0.5 1,283 18.9 13,945 17.2 70 0.6 10,868 

loss corporations 29 -8,167 2,329 34.3 12,586 15.5 5,403 

Office of the Secretary of the Treasury 

Off ice of Tax Analysis 

y Compensation of employees was canputed by multiplying 1.221 times payroll. 'llle 22.1 percent reflects the employer-paid portion of social security, 

unemployment insuraoce, an:i other non-payroll costs. '!he 22.1 percent is the avera;ie for all u.s. manufacturinJ imustries in 1978; see the U.S. 

Department of carrnerce, Survey of Current Business, July 1979, Tables 6.5 am 6.6. 

I 

...... 

N 

......i 

I 
-128-

Appendix B -- Expenditures on Puerto Rican Inputs as a 

Percentage of the Value of Production, Selected 

Puerto Rican Industries 

Table B-1, discussed on pages 55-5 7, above, shows the 

breakdown of the value of production in selected Puerto 

Rican manufacturing industries between the cost of imported 

materials, the cost of Puerto Rican materials, and labor 

costs. All statistics are expressed as a percentage of 

value added plus cost of materials. 
Table B-1 

Expenditures on Materials, Labor, Plant, and Equipment 

as a Percentage of the Value of Production by Manufacturing Establishments in Puerto Rico, 1977** 

All Manufacturing Food and Tobacco Textile Lumber and : 

Industries Kindred Products Products Mill Products Apparel Wood Products: 

Cost of Materials from 

All Sources .!/ 58.7 66.6 40.1 82.6 58.7 56.3 

Cost of Materials from 

Puerto Rico ~/ 28.8 51. 3 12.8 22.3 18.8 18.0 

Value Added .. !/ 41.3 33.4 59.9 17.4 41. 3 43.7 

Labor Costs ii 11. 2 11. 7 12.3 19.0 28.8 22.2 

Return on Capital and 

Overhead Costs y 30.1 21. 7 47.6 - 1.6 12.5 21. 5 

Expenditures on New Plant ~/ 2.1 1.1 .1 .1 .1 .2 

Expenditures on New Equipment ~/ 2.2 3.2 2.2 .9 .8 1. 0 

Expenditures on Used Equipment ~/ * .3 .5 * .4 * 

Total Expenditures on Materials, 

Labor, Plant, and Equipment in 

Puerto Rico y 42.2 64.9 26.2 41. 6 48.3 40.6 

Ratio of Labor Costs to Total 

Expenditures in Puerto Rico .265 .180 .469 .457 .596 .547 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Less than 0.05 percent 

** All figures except expenditures on plant and equipment are based on preliminary data to be published in the 1977 Economic 

Census of Outlying Areas, Manufactures, Puerto Rico. See footnotes 1 and 2 at the end of the table. 

I 

...... 

N 

\C 

I 
Table B-1 continued 

Rubber Products Leather and Stone, Clay and Primary Fabricated Machinery 

Leather Products Glass Products Metals Metal Products :ExceEt Electrical: 

Cost of Materials from 

All Sources y 37.6 55.0 56.8 49.8 59.6 46.5 

Cost of Materials from 

Puerto Rico ±_/ 12.0 10.5 48.3 26.9 19.1 14.9 

Value Added y 62.4 45.0 43.2 50.2 40.4 53.5 

Labor Costs ll 22.0 28.0 20.3 17.2 18.6 12.3 

Return on Capital and 

Overhead Costs y 40.4 17.0 22.9 33.0 21. 8 41. 2 I 

Expenditures I-' 

on New \;.) 

0 

Plant ~/ .2 * 1.6 1.1 1. 4 .2 I 

Expenditures on New 

Equipment .V .2 .5 4.2 5.4 2.4 1. 6 

Expenditures on Used 

Equipment ~/ 2.2 * . 2 .1 * 

Total Expenditures on Materials, 

Labor, Plant, and Equipment in 

Puerto Rico ~/ 36.4 38.6 71. 0 46.1 39.4 27.7 

Ratio of Labor Costs to Total 

Expenditures in Puerto Rico .604 • 725 .286 .373 .472 .444 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Less than 0.05 percent. 
Table B-1 continued 

Furniture Paper and Printing and Chemicals Petroleum 

and Fixtures Allied Products Publishing Refining 

Cost of Materials from 

All Sources .!/ 47.2 67.6 24.2 42.9 93.6 

Cost of Materials from 

Puerto Rico y 25.0 29.1 14.8 19.3 39.3 

Value Added .!/ 52.8 32.4 75.8 57.1 6.4 

Labor Costs ll 29.5 19.1 36.5 5.7 2.1 

Return on Capital and 

Overhead Costs y 23.3 13.3 39.3 51. 4 4.3 I 

I-' 

Expenditures on New Plant 2.1 3.7 3.3 3.0 4.3 5.5 VJ 

I-' 

I 

Expenditures on New 

Equipment 2_/ 1. 2 8.1 3.9 3.0 .2 

Expenditures on Used 

Equipment 2_/ . 2 .2 * * 

Total Expenditures on Materials, 

Labor, Plant, and Equipment in 

Puerto Rico y 58.0 52.7 54.5 29.0 45.8 

Ratio of Labor Costs to Total 

Expenditures in Puerto Rico .509 .362 .670 .197 .046 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

* Less than 0.05 percent. 
Electrical and 

Electronic Equipment 

Cost of Materials from 

All Sources _!/ 

Cost of Materials from 

Puerto Rico '!:_/ 

Value Added .!/ 

Labor Costs ll 

Return on Capital and 

Overhead Costs !/ 

Expenditures on New Plant ~/ 

Expenditures on New 

Equipment ~/ 

Expenditures on Used 

Equipment ~/ 

Total Expenditures on Materials, 

Labor, Plant, and Equipment in 

Puerto Rico ~/ 

Ratio of Labor Costs to Total 

Expenditures in Puerto Rico 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

* Less than 0.05 percent. 

44.7 

14.3 

55.3 

16.8 

38.5 

2.7 

1. 3 

• 2 

33.8 

.497 

** Includes photographic goods and watches. 

Table B-1 continued 

Transportation 

Equipment 

41. 5 

13.3 

58.5 

20.0 

38.5 

* 

.9 

.1 

33.6 

.595 

Scientific 

Instruments** 

43.l 

13.8 

56.9 

19.3 

37.6 

.5 

1.8 

.1 

34.0 

.568 

Miscellaneous 

Manufacturing 

Industries 

64.0 

20.5 

36.0 

16.5 

19.5 

1.2 

• 6 

.1 

38.2 

.432 

I 

...... 

(..,) 

N 

I 
Table B-1 continued 

~: 

ii 

~/ 

Based on preliminary figures from the U.S. Department of Commerce, to be published in the 1977 

Economic Census of Outlying Areas, Manufactures, Puerto Rico. All statistics are expressed as a 

percentage of value added plus cost of materials. 

Percentage of cost of materials from Puerto Rico is estimated by multiplying the cost of 

materials from all sources by the share of intermediate imports in total intermediate inputs. 

This latter share was estimated by Richard Weisskoff and Edward Wolff, "Development and Trade 

Dependence: The Case of Puerto Rico, 1948-1963," Review of Economics and Statistics, November 

1975, Table 2, p. 474. These import shares are based on 1963 data; more recent information is 

unavailable. Whether the degree of dependence on imported inputs for individuals industries 

decreased between 1963 and 1972 is impossible to determine, but the ratio of Puerto Rican 

imports of capital goods, raw materials and other intermediate goods to the value of shipments 

for all industries decreased only slightly over this interval. 

Labor costs are estimated by multiplying total payroll, as reported for 1977 by the U.S. 

Department of Commerce, op. cit., by 1.212. The additional 21.2 percent reflects the employerpaid portion of social security, unemployment insurance and other non-payroll labor costs. The 

21.2 percent is the average for all U.S. manufacturing industries in 1977; see the U.S. Department of Commerce, Survey of Current Business, July 1978, Tables 6.5 and 6.6. 

Value shown equals the difference between value added and labor costs. The return on capital 

includes not only profits, but also interest expenses, depreciation, expenditures on accounting 

and legal services, and any other overhead costs. 

Based on U.S. Department of Commerce, 1972 Economic Census of Outlying Areas, Manufactures, 

Puerto Rico, October 1974, Chapter 2, Table 2. All statistics are expressed as a percentage of 

value added plus cost of materials. 

Value shown equals the sum of the cost of materials from Puerto Rico, labor costs, 80 percent of 

expenditures on new plant, 21 percent of expenditures on new equipment and total expenditures on 

used equipment. The 80 percent of expenditures on new plant corresponds to the estimated ratio 

of expenditures on Puerto Rican inputs to total expenditures by the construction industry, as 

reported in Weisskoff and Wolff, op. cit. The 21 percent of expenditures on new equipment 

corresponds to the ratio of the value of shipments of machinery except electrical with a Puerto 

Rican destination to total expenditures for new equipment by all manufacturers, as reported for 

1972 by the U.S. Department of Commerce, £12.· cit., Chapter 2, Table 3. 

I 

...... 

w 

w 
-134-

Appendix C - Historical Data and Sources and Limitations 

of the Data 

Historical Data 

·rable C-1 presents selected data items for 1973-1978. 

Some of the corporations included in 1973-1975 are included 

solely on the basis of being related to an electing 936 

corporation and having benefitted from section 931 in at 

least one of these years. These corporations, for various 

reasons, have not made an election under section 936 and 

therefore do not appear after 1975. Since most of the nonelecting 93ls were in non-manufacturing industries, the 

number of possessions corporations engaged in manufacturing 

has remained relatively constant while the number for nonmanufactur ing dropped sharply from 1975 to 1976. There is 

no corresponding drop in the income figures, however, 

because the non-electing 931 corporations were, in general, 

either inactive or loss corporations. 

Table C-2 is similar to Tables 8 and 10 and covers tax 

year 1977. Table 6 of the Second Annual Report included 

data for the 4 79 corporations for which in format ion was 

available in time for the report. Table C-2 is based on the 

complete file of 519 corporations benefitting from section 

936 in 1977. 

Sources and Limitations of the Data 

All of 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 19 78 contain data 

for corporations with accounting periods ending on or after 

July 1, 1978 and on or before June 30, 1979. 

Income statement and balance sheet data for 1977, 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 
-135-

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 therefore 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 tax expenditure estimates, which are based on the income -0f profitable firms only. In addition to Form 5712, some income data 

and all of the Puerto Rican tax data available on an individual company basis were ~btained from income tax returns 

(Forms 480.20) filed with the Puerto Rican Government. 

The employment and payroll data for all years was 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 was associated with income data for the 

accounting period most nearly corresponding to the calendar 

Year. For example, the calendar year 1978 Form 940 data was 

associated with annual accounting periods ending between 

July 1, 1978 and June 30, 1979. 

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 

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 overestimate employment for a company with relatively high wages 

ana part-time employees or a high labor turnover rate. 

However, secondary data from Forms 940 and other sources 

suggest that the method used here provides reasonably 

accurate estimates of full-time equivalent employment. 

11 For 1973-1977, the corresponding amount was $4,200. 
-136-

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. The 

value of this factor is noted in the tables for each year. 

Total compensation exceeds total remuneration because it 

includes certain fringe benefits and other i terns, such as 

the employer share of social security contributions, that 

are excluded from total remuneration. 
Table C-1 

Sunmary Data on Possessions Corporations, 1973- 1978 y 

1973 1974 1975 1976 1977 1978 

Nll'!lber of corporations, all industries 568 596 595 528 519 534 

Manufacturing industries 385 399 394 395 385 374 

Pharmaceuticals 39 44 47 52 53 55 

Electrical and electronic equipnent 64 76 76 81 80 80 

All other manufacturing 282 279 271 262 252 239 

Nollllanufacturing industries 183 197 201 133 134 140 

Net incane, all industries ($000} 650,515 852,058 1,108,881 1,627,213 1,800,313 2,383,263 

Manufacturing industries 591,724 813,057 1,055,060 1,551,677 1,714,321 2,244,528 

Pharmaceuticals 251,897 405,355 547,060 779,954 876,576 1,078,478 

Electrical and electronic equipnent 116,277 167,389 195,593 323,249 231,475 304,889 

All other manufacturing 223,550 240,313 312,407 448,474 606,270 861,161 

Normanufacturing industries 58,792 39,002 54,059 75,536 85,992 97,424 

Estimated tax expenditures, all 

manufacturing industries y ( $000} 242,116 352,908 425,213 621,190 685,728 839,342 

Pharmaceuticals 103,533 161,341 218,210 311,948 350,630 412,286 

Electrical and electronic equipnent 46,749 66,872 79,164 129,400 92,590 125,054 

All other manufacturing 91,834 124,695 127,839 179,842 242,508 302,002 

Tax expenditure per employee, y all 

manufacturing industries ($} 2,287 5,609 7,566 10,181 9,971 12,667 

Pharmaceuticals 27,239 33,892 34,694 41,925 34,966 43,261 

Electrical and electronic equipnent 2,995 5,544 8,434 9,614 10,058 10,656 

All other manufacturing 1,317 3,092 3,544 4,711 3,939 8,568 

Tax expenditure as a percent of canpensation of employees, 3/ all 

manufacturing industrTes 38.9 81.5 103.2 127.4 120.8 l18.4 

Pharmaceuticals 377.1 378.2 345.9 380.5 291.1 317.6 

Electrical and electronic equipnent 47.7 83.1 l12.0 114.8 112.5 100.1 

All other manufacturing 23.8 46.8 49.6 64.3 55.3 84.1 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

y Includes data for possessions corporations operating in American Samoa, Guam, and the Panama Canal Zone. These 

non-Puerto 1Rican operations account for less than 2 percent of total tax expenditure in any year (see Table 1). 

Y Note that the figures shown here differ fran the corresponding years shown in Table 1 because Table 1 is based on calendar and (Federal} fiscal years, whereas the data in this and table is based on the taxable years of 

possessions corporations, as explained more fully in the text. 

y These figures are based only on those returns for which employment and canpensation of employees were available. 

See text. 

I 

....... 

w 

...... 

I 
Table C-2 

Nunber of Possessions Corporations, Selected Incane arrl Balance Sheet Items arrl Estimated Tax Expeooiture, by Iooustry, 1977 

{Dollar anounts in thousands) 

All Manufacturi!!I Industries 

Iooustries Total Food & Kioored:Tobacco : Textile Apparel Chemicals 

Products :Products:Mill Products: Total :Pharmaceuticals:All Other: 

Nunber of returns 519 385 18 4 14 77 75 53 22 

Balance sheet items 

Total assets 10,024,974 7,761,381 643,098 141,173 77,431 303,775 4,266,955 3,639,956 626,999 

Retained earnings 6,216,249 6,063,497 515, 793 84,539 65,273 235,274 3,367,155 3,013,579 353,576 

Income statement items 

Business receipts 5,968,255 5,309,106 586,020 187 ,174 77, 746 324,720 2,123,094 1,603,274 529,820 

Cost of sales arrl operations 3,418, 761 3,011,067 390,644 85,075 68,179 251,718 814,628 469,413 345,215 

Non-government interest 261,006 182,600 19 ,092 2,814 534 2,527 108,328 105,660 2,668 

Net incane per return 1,800,313 1,714,321 ll5, 795 22, 541 7,207 61,678 1,008,577 876,576 132,001 

Net income per books 1, 795,821 1,727,851 145,144 22,209 6,581 66,146 l,003,ll6 876,656 126,460 

Estimated tax expeooiture 685, 728 685, 728 46,318 9,016 2,883 24,671 403,431 350,630 52,800 

Office of the Secretary of the Treasury 

Office of 'I'ax Analysis 

RUbber 

Products 

10 

52,155 

38,877 

46,894 

27,8ll 

642 

8,195 I 

..... 8,070 VJ 

00 

3,278 I 
Leather arrl 

Leather Products 

Nunber of returns 

Balance sheet items 

Total assets 

Retained earnirlJS 

Income statement items 

Business receipts 

Cost of sales 

Non-government interest 

Net incane per return 

Net income per tx:>oks 

Estimated tax experrlitures 

Off ice of the Secretary of the Treasury 

Office of 'I'ax Analysis 

* InclLrles p.hot03raphic goods arrl watches 

11 

44,156 

36,352 

42,413 

33, 839 

539 

5,272 

5,300 

2,109 

Table C-2 - continued 

Manufacturing Industries - continued 

Stone, Clay, & Fabricated Machinery, Electrical arrl 

Glass Products :Metal Products Except Electrical Electronic Equipnent 

5 

28,452 

24,317 

28,054 

18,139 

462 

6,312 

6,400 

2,525 

16 

137,316 

112, 712 

80,471 

56,088 

3,299 

23,591 

23,743 

9,436 

9 80 

73,641 1,137,437 

62,557 936,670 

63,691 556,909 

37,845 304,758 

1,338 32,971 

23,084 231,475 

23,425 232,340 

9,234 92,590 

: Trans,EX>rtion 

Equipnent 

5 

42,857 

36,484 

35,160 

20,750 

723 

12, 64 7 

12,331 

5,059 

Scientific* 

Instruments 

25 

192,478 

161,967 

154,672 

66,685 

2,642 

68,158 

68,294 

27 ,263 
Table C-2 - continued 

All other Transportation 

Norunanufacturi!!9 Industries 

Finance, Miscellaneous 

Manu- Total COnmunications Wholesale Retail Insurance, Services and 

facturin9 and Utilities Trade Trade Real Estate Not Available 

Ntnuber of returns 36 134 9 24 44 23 15 19 

Balance sheet items 

·rotal assets 620,456 2, 263, 593 623,912 38,620 110,053 1,400,629 38,560 51,819 

Retained earni03s 385, 527 152,752 3,124 13,514 29,193 58,862 14,057 34,002 

Income statement items 

Business receipts 1,002,088 659,149 164,090 77,218 305,292 13, 967 34,302 64, 280 

cost of sales 834, 908 407,694 64,743 53, 728 221,059 1,374 18,958 4 7,832 

Non-government interest 6,689 78,406 95 81 203 77,535 74 418 

Net inccme per return 119,789 85,992 43,460 4,876 10,756 9,275 4,912 12, 713 

Net income fer books 104, 752 67, 970 42,967 3,838 5,437 7,482 4,611 3,635 

Estimated tax experrlitures 4 7 ,916 

I Office of the Secretary t--' 

Office of Tax Analysis ""' 0 

I 
Appendix D -- Tax Forms from which Data Included 

in this Report was Obtained 
Form 1120 U.S. Corporation Income Tax Return 

Internal 

Department Revenue of the Service Treasury For calendar year 1978 or other taxable year beainnlna ~®78 -······-·- --·------·----·-·-·----·-• 1978, endlni:r ---··-······-···-····-··············• 19 ....... . 

Check If e- Use 

IRS 

label. 

Otherwise 

please 

print 

or type. 

Name D Emplorer ldenUflcatlon number (SH instruction W) 

A Consolidated return 0 8 Personal Holdln1 Co. 0 C Business Code No. (Ste 

Number and street E Date Incorporated 

Pa11 8 of instructions) City or town, State, and ZIP code F Enter total assets (see Instruction X) 

4D 

E 

0 

u 

.s 

Cl) 

.§ 

-

u 

~ 

$ 

1 Gross receipts or eross sales .... ---·---------·-·----------------Less: Returns and allowances.................................... 1 •••••••••••••••••••••••••••••. 

2 Less: Cost of goods sold (Schedule A) and/or operations (attach schedule) 

3 Gross profit 

4 Dividends (Schedule C) 

5 Interest on obligations of the United States and U.S. Instrumentalities 

6 Other interest • 

2 

3 

4 

5 

6 

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

------------------------------ ------------------------------ 7 Gross rents 

8 Gross royalties 

9 (a) Capital gain net income (attach separate Schedule D) • 

(b) Net gain or (loss) from Fonn 4797, line 11, Part II (attach Form 4797) • 

10 Other income (see lnstructions--attach schedule) 

_7 - ······------------------------

_8 _ ------------------------------

9(a) ------------------------------

•. ~ ------------------------------ 10 

11 TOTAL income-Add lines 3 through 10 11 

12 Compensation of officers (Schedule E) __!!__ ···---------------------------· 13 (a) Salaries and wages........................ 13(b) Less new jobs credit·-··----·--·--------·---

14 Repairs (see Instructions) 

Balance .... 13(c) ------------------------------

15 Bad debts (Schedule F If reserve method Is used) 

16 Rents 

17 Taxes 

18 Interest • 

19 Contributions (not over 5% of line 30 adjusted per lnstructlon..-attach schedule) 

20 Amortization (attach schedule) 

21 Depreciation from Form 4562 (attach Form 4562) ----··--·--··--·--------.. ·-··· .. ···----• less depreciation 

claimed in Schedule A and elsewhere on return ........................................................ , Balance .... 

22 Depletion 

23 Advertising • 

24 Pension, profit-sharing, etc. plans (see instructions) (enter number of plans ... ····----···-··> 

25 Employee benefit programs (see Instructions) 

26 Other deductions (attach schedule) 

27 TOTAL deductions--Add lines 12 through 26 • 

~ -----------------------------· 15 16 ------------------------------ 17 -----------------------------· 

------------------------------ _!!_ ----------------------------·· 

_!!_ ------------------------------ 20 -----------------------------· 

21 

22 -----------------------------· 

23 -----··-------------------·---

------------------------------ ~ 

24 ------------------------------ 26 ------------------------------

27 

28 --------------------------· --- 28 Taxable income before net operating loss deduction and special deductions (subtract line 27 from line 11) • • 

29 Less: (a) Net operating loss deduction (see Instructions-attach schedule) • • , 29(a) 1------------------------ (b) Special deductions (Schedule I) • • .__ 2-'9 ...... (_,b):....:.... ______ 11

_29_, _______ _ 

30 Taxable income (subtract line 29 from line 28) 30 

31 ·-----------------------------· 31 TOTAL TAX (Schedule J) • • • • • • • • • • • • • • 

32 Credits: (a) Overpayment from 1977 allowed as a credit • • • 1-----------------------· 

(b) 1978 estimated tax payments • • 

(c) Less refund of 1978 estimated tax applied for on Form 4466 ." ·c··-------------·-·;------------------------ (d) Tax deposited: Form 7004 ...................... Form 7005 (attach) ...................... Total .... 

(e) Credit from regulated investment companies (attach Form 2439) 

(f) U.S. tax on special fuels, nonhighway gas and lubricating oil (attach Form 4136). _3_2_ 1 ________ _ 

33 TAX DUE (subtract line 32 from line 31). See instruction G for depositary method of payment. 33 

34 

(Check 

OVERPAYMENT 

.... O if Form 

(subtract 

2220 

line 

is attached. 

31 from 

See 

line 

page 

32) 

3 

• 

of instructions.) .... $ ........................... ___________ -

_3_4_1

, 

~ 

_______ _ 

35 Enter amount of line 34 you want: Credited to 1979 estimated tax .... Refunded .... 35 

! Under penalties of perjury, I d~lare that I have examined this return, lncludin1 1ccomp1nylng schedules ind statements, ind to the best of my knowledee ind belief, It is true, ~ correct, and complete. Declaration of pre)llrer (other thin texpeyer) Is based on all lnform1tlon of which preperer has 1ny knowledee. 

:z: 

.§ ~ S11rnature of officer Cl) batal ~T~iTltl~e----------------

I 

i 

Paid 

Preparer's 

Information 

Preparer's 1111.,. 

signature r I Preparer;s soci~I security no. I : : 

Check if self· 

employed ~ 0 

Firm's name (or yours, 1111.,. I E.I. No ..... 

~d~~~~~~~~~~~~oder •~---------------------,r·-o-a_t_e-..,.--=:........--...:....-------
Form 1120 (1978) 

9'111trtfimt&W Cost of Goods Sold (See instruction 2) 

1 Inventory at beginning of year • 

2 Merchandise bought for manufacture or sale • 

3 Salaries and wages • 

4 Other costs (attach schedule) • 

5 Total • 

6 Less: Inventory at end of year • 

7 Cost of goods sold-Enter here and on line 2, page 1 

8 (a) Check valuation method(s) used for total closing inventory: 

D Cost D Lower of cost or market D Other (if "other," attach explanation) 

(b) Check if this is the first year LIFO inventory method was adopted and used. (If checked, attach Form 970.) • 

(c) If the LIFO inventory method was used for this taxable year, enter percentage (or amounts) of closing in· 

ventory computed under LIFO. 

(d) Is the corporation engaged in manufactu·ring activities? • 

If "Yes," are inventories valued under Regulations section 1.471-11 (full absorption accounting method)? • 

(e) Was there any substantial change in determining quantities, cost, or valuations between opening and closing inventory? • 

If "Yes," attach explanation. 

•i§@mNM Dividends (See instruction 4) 

1 Domestic corporations subject to 85% deduction 

2 Certain preferred stock of public utilities • 

3 Foreign corporations subject to 85% deduction • 

4 Dividends from wholly-owned foreign subsidiaries subject to 100% deduction (section 245(b)) • 

5 Other dividends from foreign corporations • 

6 lncludable income from controlled foreign corporations under subpart F (attach Forms 3646) • 

O Yes 

O Yes 

O Yes 

Pap 2 

·D 

D No 

D No 

D No 

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 line 1 (section 246{d)) • 

10 Other dividends 

11 Total-Enter here and on line 4, page 1 . A-§ffitmt'IW Compensation of Officers (See instruction 12) 

1. Name of officer 2. Social security number 

3. Time Percent of corporation 

devoted to stock owned 

business 4. Common 5. Preferred 

6. Amount of 

compensation 

7. Expense account 

allowances 

------------------------------------------------- ·---------------------------------- ------------- -·----------- ------------- ·---------------------- ----------------------- -------------------------------------------------- ----------------------------------· -------·----· ------------· ------------- ----------------·--··-· ----------------------- ------------------------------------------------- ·---------------------------------- ·------------ ------------- ------------- ----------------------· ----------------------- ----------------------... ----------------------.. ---· ·---------------------------------- ·------------ . ------------· .... ---------------------------------- ·----------------------· ------------------------------------------------ ----------------------------------· -------·----- -----------~- ------------- ·----------------------· ·---------------------- -------------------------------------------------------------------------------------------------------------------------------·1-------·l:m== 

Total compensation of officers-Enter here and on line 12, page 1 

•i'i1ittimfWM Bad Debts-Reserve Method (See instruction 15) Amount added to reserve 

1 Var 2. Tr1de notes end accounts re· ' ceivable outstandine at end of year 3. Sales on account 6. Amount charged 

against reserve 

7. Reserve for bad debts 

at end of year ~ 

1973 

1974 

1975 

1976 

1977 

1978 

----------..... -... ---------... --... ---..... ----- -----------------... ---------. . ... ----.... ---... ------------... ---... .. -----... --...... -... ---------· ----------------------.. --........ ---... ------------· ·-------------·-----·---·------------ --------------------------· ---------------------------- ·---------------------- ·----------------------· -----------·----------· ..... --... -.. -------.. ---------------------- ------... -------------.. ------ ------------.................... ---... -----· ----------------------· ------· ---------.. ----... .. . ... --------------------· ... --...... --.. --..... -.. ----... ------------------ . ---------------.. -.. -----... --· . ----------... -------... --------- --------.. ------------...... ----------------------.. ---------------------- ... -----.. -------------------... -------.. -... . ---... -------------... -------- .... ------...... -----.... -----........ ---- . --... ----... ------... ------- ---... ------------... ---... -- ... ------------·-----

Schedule I Special Deductions 

1 (a) 85% of Schedule C, line 1 • 

(b) 60.208% of Schedule C, line 2 • 

(c) 85% of Schedule C, line 3 • 

(d) 100% of Schedule C, line 4 • 

2 Total-See instructions for limitation • 

3 100% of Schedule C, line 8 • 

4 Dividends paid on certain preferred stock of public utilities (see instructions) • 

5 Western Hemisphere trade corporations (see instructions) • • • • • • • • • 

6 Total soecial deductions-Add lines 2 through 5. Enter here and on line 29{b), page 1 . 

·---------------------- . ----------------------· 

----------------------- 1---------

. ----------------------· . ----------------------· 

----------------------- 1----------
Form 5712 

(Rev. March 1978) 

Deputment of the Treasury 

Internal Revenue Service 

Election to be Treated as a 

Possessions Corporation Under Section 936 

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 

Number and street 

City or town, State and ZIP code 

Business code number I Principal business activity 

Description of each class of stock 

Employer identification number 

Date of incorporation 

Place of incorporation 

Principal product or service 

Number of shares 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 shareholder Identifying number Address Class of stock Number of shares owned 

~lection is made for the taxable year beginning (month, 

ay, Year) Date corporation commenced busi· 

ness in a U.S. possession 

Annual return will be filed for the taxable year 

ending (enter the month or "unknown") 

For any taxable year beginning in 1973, 1974, or 1975 did you, or any other corporation which is (or was in that 

Year) a member of your controlled group (as defined in section 993(a)(3)), exclude income under section 931? . . D Yes D No 

If "Yes," for ea.ch such corporation (attach additional schedules if required): 

((2

1

> Enter the corporation's name and employer identification number ,... ·---·-----------·----·--------------···-------.. ------------··-----------------·-

-lSomplete the following scheduleTaxable year (use a separate line for each full or short taxable year --- beginning in 1973, 1974, or 1975) 

Beginning Ending -----(month/day/year) (month/day/year) 

Principal place of business (enter name of U.S. possession or country) 

------ U.S. income tax returns filed: 

Net income per books 

__________ 1_f_c_o_r~po_r_a_ti_o_n_f_il_e_d_s~e~p-a_ra_t_el~y-=~~~~~·l-~~~~~~~-l_f_c_o~rp_o_r_at_io_n_;_jo_i_n_ed~i-n_f_il_in~g-a~c-o_n_so_l_id_a~te_d~re_t_u_rn_:~~~~~~~­

Taxable income or (loss) 

--_:>hown on return 

'"--......... 

Amount of gross income excluded under section 931 

Name and employer identification number of corporation filing return 

Internal Revenue Service Center in which return was filed 

of rnyU~der 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. 

~ 

si&iiiiiure··-·-··-----------------····--··-·--··-················--·-··-·-··-·-·········--·-········-----·-····-·--·-···--·-···-·-·--·- and title of officer 

oaiii ___________________ _________ _ 

Form 5712 (Rev. 3-78) 
Instructions 

Who Can Elect 

Only domestic corporations can elect to be treated 

as possessions corporations. 

When to File 

Form 5712 must be filed within 90 days after the 

beginning of the first taxable year for which such election is made. 

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, Computation of Possessions Corporation Tax Credit Under 

Section 936, and attach it to your income tax return. 

Consolidated Returns 

A corporation may not join in filing a consolidated 

return for any year for which an election under section 

936(e) is in effect. 

Business Classification 

Refer to the Codes for Principal Business Activity 

and Principal Product or Service in the Instructions for 

Form 1120 and enter the (1) business code number, (2) 

principal business activity, and (3) principal product or 

service. 

Identifying Number 

The identifying number for individuals is their 

social security number. For all others it is their employer 

identification number. 

Signature 

This form must be signed by the president, vice 

president, treasurer, assistant treasurer, chief account· 

ing officer, or other corporate officer (such as tax officer) 

who is authorized to sign. 
Form 573~979) (Rev. J•nu•~. Treuury 

Depart nt of J. S.rviC9 lntwnal Reven 

Corporation putatlon of Po~s~:~:;~ectlon 936 CTo: Credit Allow~ to,..,, ............ 

or o ther taxable year 

~ Att•c 

beginning --·····-·---····---·····-·-·• 19 _________ _ ,and 
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. 

B. 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(f).) 

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 section 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 earned 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 Income.-

( l) 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 sale 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 loss to 

qualified taxable income in proportion to the ratio of qualified 

taxable income to total taxable income (excluding the loss). 

(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 re· 

duction for the "rate differential portion" of the net capital 

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., 

to the extent taken into account in determining capital gai~ n~! income, the loss, decreased by the "rate differential portion 

of the excess of net capital gain from non-qualified sources 

over net capital gain, is used to reduce income against which 

the credit is allowed. Enter on line 9(c) this reduction and at· 

tach computation. 

Line 12.-lf the taxable income of the corporation includes 

income from the sale or exchange of capital assets in line 11 t 

enter the reduction for the "rate differential portion" of ne 

capital gain. 

I. Coordination with Foreign Tax Credit.-Qualified taxable 

income is not taken into account in computing the foreign tax 

credit limitation. (Section 904(b).) 

J. Where to File.-Attach Form 5735 to your tax return a~d file it with the Internal Revenue Service Center, Philadelphia, 

PA 19255. 
Form 940 Employer's Annual Federal 

Dellmtment 

lnterml Revenue 

of the 

Service 

Treasury Unemployment Tax Return ~®78 

T 

r I FF Name Cu dlltlnplslled from trade name) Calendar Y•r FD If Incorrect, 1978 make any~ FP 

necessary 

Trade name, If 1111 Employer ldenUflCltlon number I 

change T 

Address 1ad ZIP code 

L _J 

Name of State Sta~rtin1 n,um!>f;r Taxable i:Tt:" Experience 4rate period ~~I· c:.i;:1::i,,0~ ';,d c;o~:1::~~:::ri~/c~ Ad:;::i~~al ~J:aW~~:r: s:te contrT~;~: :r:s Cu defined In tltl let) 1-----r-----1 rate {col. 3 x 2.7%) rate (col. 3 x col. 5) (col. 6minuscol. 7) to State 1 2 3 From- To- _5_1 ___ 6;;_ __ 1 ___ .....;7._ __ 11 

___ 8 ___ 1 ___ 9__ 

-··---··---·-----·-----;:~j;·-~· 1----1~ ~ ~ ~ ~ 

10 Total tentative credit (column 8 plus column 9-see instructions on page 4) • • • • • • • • • 

11 Total remuneration (including exempt remuneration) paid during the calendar year for services of employees 

12 ~~~-~€~~ff ~~~~~~~~~~~~~~~~~~f~:~~~~~:~;~:: :::~~~~;~:::: :::;;:~~:~::: (11 

$6,000 in column (b), paid to_ individual employees exclusive of exempt --· amounts entered on line 12. Do not use State wage limitation • • • • •• 

i: :a:;~~::::::lt•=1 :g~:"~.:!:~: :::: ~:'. ~l~m~ (~) f~,,; li~e ;1): ~ ·--~. b New jobs credit wages (subtract line 14, column (a) from line 11) • • • ~ ... 

c Total taxable FUTA wages (subtract line 14, column (b) from line 11) • 

16 Gross Federal tax (multiply line 15c by .034) • 

17 Maximum credit (multiply line 15c by .027) • 

18 Line 10 or line 17 whichever is smaller. • • 

19 Amount, if any, of wages on line 15c attributable to Rhode Island $ ........................ x .003 • 

~ ,_: ___ :_~ __ : _________________________ I 

20 Credit allowable (subtract line 19 from line 18) • • • 

~ Net Federal tax (subtract line 20 from line 16) • 

- Quarter Uabllity by period 

- First 

- Second 

- Third 

- Fourth 

-===·:=R=ecord=of-F-edera=I Tax=Dep=osits~f:o=-r U-=-n:_t~_·::m_de_::_:_ax (-F-o

11

--rm-5-08A-)m-oun-t of d-epo-sit-=--ilw• I 

22 Total Federal tax deposited • • • • • • • • • • • • • • • • • • • • • 

23 Balance due (subtract line 22 from line 21-this should not exceed $100). Pay to Internal Revenue 

Service • • • • ~ 

~Overpayment (subtract line 21 from line 22). • • • • • ~ 

~f no longer in business at end of year, write "Final" here • • ~ ~1~' Ptn11ties of perjuiy, I decl1re th1t I hrn eXlmined this return, lncludln11ccompanylng schedules and statements, 1nd to the best of my knowled1e ind belief, It ls true, correct ind corn- , and that no part of any p11yment rude to 1 Stata unemployment fund claimed 11 1 credit was or Is to be deducted from the remuneration of employees. 

Slanature • Title (Owner, etc.) ~ 

Form 940 (1978) 
Form 940 (1978) 

Effective January 1, 1978-

(1) Wage base increased to $6,000; 

(2) Coverage extended to certain agricultural 

and domestic service employees; and 

(3) U.S. Virgin Islands employers are subject 

to FUTA. 

General Instructions 

For more detailed information on which 

employers must file, the types of payments defined by law as wages, and the 

kind of services covered by the Federal 

Unemployment Tax Act (FUTA), see Publication 15, Circular E, Employer's Tax 

Guide. Publication 539, Withholding Taxes 

and Reporting Requirements, has exam· 

pies and a filled in copy of Form 940. Both 

publications are available at any Internal 

Revenue Service office. 

Household employers, see Publication 

503, Child Care and Disabled Dependent 

care. Publication 503 includes an example and a filled in copy of Form 940 for a 

household employer. 

Purpose of Form 940.-Use it for the 

annual reporting of tax under FUTA, which 

is paid only by the employer. The tax rate 

is 3.4 percent on the first $6,000 of wages 

paid to each employee during 1978. 

Who Must File.-ln general, every em- ployer who during 1978 or 1977 paid 

wages of $1,500 in any calendar quarter or at any time had one or more employees 

in any 20 calendar weeks must file. Count 

all regular, temporary, and part-time em- ployees. A partnership should not count its 

partners. If a change of ownership or other 

transfer of the business occurs during the 

year, each employer who meets the $1,500 

a quarter or one or more employees in 20 

weeks tests must file, but neither should 

report wages paid by the other. Organizations described in section 50l(c)(3) are not required to file. 

Beginning in 1978, employers who (1) 

paid cash wages of $20,000 or more to 

agricultural workers during any calendar 

quarter beginning on or after January 1, 

1978; or (2) employed 10 or more agri· 

cultural workers during some portion of a 

day (whether or not at the same time) for 

at least one day during any 20 different 

weeks beginning on or after January 1 

1978. (Aliens admitted to the U.S. on ~ temporary basis to perform agricultural 

labor are excluded until January 1 1980 )· 

or (3) paid cash wages of $1,0001or mo~~ In any calendar quarter beginning on or 

after January 1, 1978, for domestic serv- ice in a private home, local college club, 

or a local chapter of a college fraternity or sorority, will be required to file Form 940. 

If you receive a form and are not liable 

for Federal unemployment tax for 1978 

write "Not Liable" across the front and 

return it to the IRS. If you are no longer 

In business at the end of the year write 

"Final" on line 25. ' 

If you sold or transferred the business 

during the year, attach a statement show1~~ th~ name, address, and employer ident1f1cat1on number (if known) of the new owner. 

Once you have filed a Form 940, we will 

send you a preaddressed form near the 

end of the year. If you do not receive it, 

request one from any IRS office in time to 

file. 

Due Date.-Form 940 for 1978 Is due 

by January 31, 1979. If you made timely 

deposits in full payment of the tax due, 

you have until February 10, 1979, to file. 

Where to File.-

If your orlnclpal bust. Fil• with the lntemal ness, office, or aaeney Revenue Service Is located In Center at 

"Y "Y 

!~l1:~; ~::Sa~~~R~~a~d? Suffolk, end Westchester Hoflsvllle, NY 00501 

New York (all other counties), Connecticut. Maine, Massachusetts, New Andllftr, MA 05501 Hampshire, Rhode Island, Vermont 

District of Columbia, Delaware, Phlladelphle, PA 19255 Maryland, Pennsylvania 

Alabama, Florida. Geo111t1, Mississippi, South C.rolina At11ntl, GA 31101 

Mlchl1an, Ohio Cincinnati, OH 45999 

Arbnsn. Kansas, Louisiana, Austin, TX 73301 New Mexico, Oklahoma, Texas 

Alaska. Arizona. Colorado, Idaho, Minnesota, Montana, Nebraska. Nevada, North Open, UT 84201 Dakota. Or11on, South Dakotl, Utah, Wnhlneton, Wyomln1 

Illinois, Iowa, Kansas City, MO 64999 Missouri, Wisconsin 

C.llfomla, Hawaii Fresno, CA 93888 

lndl~na, Kentuclcy. North C.rollna, Tennessee, 

Virilnla, West Vlralnla Memphis, TN 37501 

If you have no legal residence or principal place of business In any lntemal Revenue Service dis- trict, or If your principal place of business ls In Puerto Rico or the U.S. Virain Islands, file Form 940 with the Internal Revenue Service Center, 

Philadelphia, PA 19255. 

Deposit Requirements.-Deposit Federal unemployment tax In an authorized 

financial institution or a Federal Reserve 

bank according to the instructions on the reverse of a preinscribed Federal Tax Deposit Form 508 which must accompany 

each deposit. 

Figure Federal unemployment tax on a 

quarterly basis. Deposit any amount due 

by the last day of the first month following 

the close of the quarter. (If you do not 

qualify as an employer until the second or 

third quarter, your d~posit requirements 

do not begin until then.) 

To determine if you must make a de· 

posit for any of the first three quarters in 

1979, comoute the total tax by multiplv· 

lng by .007 that part of the first $6,000 

of each employee's annual wages you paid 

during the quarter. 

If the amount subfect to deposit (plus 

the undeposited amount for any prior 

quarter) is more than $100, deposit it 

during the first month following the quarter. If the amount is $100 or less, you do 

not have to deposit It, but you must add 

it to the amount subject to deposit for the 

next quarter. 

If the tax reportable on Form 940 less 

amounts deposited for the year Is more 

than $100, deposit the entire amount by 

January 31. If the tax for the year less 

any deposits is $100 or less, either deposit it or pay it with Form 940 by Janu· 

ary 31. 

If you deposited the proper amounts 

following these rules, the balance due will 

not exceed $100. 

How to Make Deposits.-Follow the In· 

structions on the reverse of the prein· 

scribed Federal Tax Deposit Form 508. 

Employer's Name, Address, and Identification Number.-Use the preaddressed 

Form 940 mailed to you. If you must use 

a nonpreaddressed form, type or print 

your name, trade name, address, and em· 

player identification number on it. 

Penalties and lnterest.-A'1oid penal· 

ties and interest by filing a correct return 

and paying the proper amount of tax when 

due. The law provides a penalty for late 

filing unless you show reasonable cause 

for the delay. If you file late, attach an explanation. 

There are also penalties for willful fail· 

ure to pay tax, keep records and make returns, and for filing false or fraudulent 

returns. Taxpayers who willfully claim 

credit for deposits not made are subject to 

fines and other criminal penalties. 

Credit for Contributions Paid into State 

Funds.-You can claim credit for contrl· 

butions you pay into a certified State un· 

employment compensation fund by the 

due date of Form 940. 

"Contributions" mean payments required by State law to be made into an unemployment fund by any person on ac· 

count of having individuals in his or her 

employ, to the extent that such payments 

are made without being deducted or ded.uctible from the employee's remunera· t1on. 

You may credit contributions against 

the tax whether or not made with res~ to "employment." You may not take credit 

for voluntary contributions or for penalties 

or interest payments to a State. 

Credit for contributions you make after 

the due date (or extended due date) for 

filing Form 940 may not exceed 90 per· 

cent of the amount that would have been 

allowable had you paid the contributions 

by the due date. 

Employers who have been granted an experience rate lower than 2.7 percent bY 

a State for the whole or part of the yea~ are entitled to an "additional credit,' 

which is equal to the difference between 

actual contributions and the amount theY 

would have been required to contribute at 

(1) the highest rate applied by the State. 

or (2) 2.7 percent, whichever is lower. 

The total credit allowable may not ei· 

ceed 2.7 percent of taxable wages. 

Computation of · 

Credit Against Federal 

Unemployment Tax 

Experience Rate.-lf a State has 

granted you an experience rate lower th ~ 2.7 percent for all or part of the taxab 

year, use columns 1 through 9. If you ha"! 

not been granted an experience rate, u~ columns 1, 2, 3, and 9 only. If you ha 1 been granted an experience rate of 2· 

(Continued on page 4) 
"- Of Stm :.":o:r:::.:~ 

1 State contrlbatloa hlblm 

--=- 2 

Employer's Annual Federal 

Unemployment Tax Return ~®78 

Contributions 

actually paid tD State 

9 

---··------··------·-·----· ----·---------·------1·-----1---- -----l------··--------1-----1------1--~ ·---------11--------1·-·------··----- ------1-------·1--------__.--1-----1-------1----1----------1-------1--------·----~ 

------·-----------·---------·-----·--------·---·1---.-----1-----------1--------·----- ------ ----------~1--------1-----1------1--l·-------1---------·-------1------ ------. -------_____ , ________ -·------·---- :::---1---;=~ •• ~ ~~~~~-~~~~ lo Total tentative credit (column 8 plus column 9--see Instructions on page 4) • • • • • • • • • • • i-------i--

ll Total remuneration (Including exempt remuneration) paid during the calendar year for services of employees !ml 

...__ Exempt Remunemtlon ($ee •--an Paae4) (el New Jobs (b)Amount • 

12 Exempt remuneration. (Explain each exemption shown, attaching additional credit wases paid •••• 

_'heat If necessatY) .. ·- I ta~~u~n~.,!'1~i~~~f~m~:m~~~!~- - .... i p11 •••

14 •mounts entered on line 12. Do not use State wage limitation • • • • Ill t • *-=~-:.pt=:=ti:!~~::a: :::: ~:'. :01~m~ (~) ,;.,.; li~e ;1): ••••••• .. .• Jj I••· 

b New Jobs credit wages (subtract line 14, column (a) from line 11) • • • - ~ ~ ~ 

l c Total taxable FUTA wages (subtract line 14, column (b) from line 11) • • • • • • • • • • • • • 1 _______ 1

_ 

6Q 

E§2.fiEES:~~t::~i:_: ~-: ~~: J-· ·_· -· ·_·_·-··-·I -I ~ 

21 credit allowable (subtract line 19 from line 18) • • • • • • • • • • • • • • • • • • • • ·-------·- Federal tax (subtract line 20 from line 16) • • • • • • • • • • • • • • • • • • • • 

~l-R-ecord_u:!.~ty_ed:;pe_I !:_Depos-its f

1

o-r Un_~~:·~_'::_:ltTax-(Fo-rm-50-~mou-nt of d-eposlt-I~~ I ~'total Federal tax deposited • • • • • • • • • • • • • • • • • • • • • • • • • • •-------•--

Balance d• (subtract line 22 from line 21-thls should not exceed $100). Pay b, Internal Revenue 

Mee • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • ~ •-------•-

~tment (subtract One 21 from line 22) • • • • • • • • • • • • • • • • • • • • ~ If no longer In business at end of year, write "Final" here • • • • • • • • • • • • • • • • ~ 

l(eep This Copy For Your Records 

Dald You must retain this copy, and a copy of each related schedule or statement for a period of 4 years after the date the tax Is due or 

• Whichever Is the later. These copies must be available for Inspection by the Internal Revenue Service. 
Form 940 (1978) 

(Continued from page 2) 

percent or higher, use columns 1, 2, 3, 

4, 5, and 9 only. If a State has granted you an experience 

rate on part of your payroll, enter sepa· 

rately in columns 1, 2, 3, and 9, that part 

to which the experience rate does not 

apply. If you were granted an experience rate 

for only part of the year or your experience 

rate was changed during the year, show 

in the appropriate columns the period to 

which each separate rate applied, your 

payroll, rate of contributions, and required 

contributions for each period. 

Column 1.-Enter the name of the 

State or States (including Puerto Rico and 

the U.S. Virgin Islands) to which you were required to pay contributions. 

Column 2.-Enter your State reporting 

number as shown on your State contribu· 

tion return. If you he!d a place of employ· 

ment in more than one State, enter the 

reporting number assigned to you by each 

State. 

Column 3.-Enter the taxable payroll on which you must pay contributions to the 

unemployment fund of the States shown in 

column 1. If you have been granted an ex· perience rate of zero, enter the amount on which you would have had to make contri· 

butions if that rate had not been granted. 

Column 4.-Enter the period(s) of the 

year to which the experience rate(s) ap· 

plies. 

Column 5.-Enter the experience 

rate(s) the State(s) granted you for the pe· 

riod(s) shown in column 4. 

Column 6.-Multiply the payroll in col· umn 3 by 2.7 percent and enter the result 

in column 6. 

Column 7.-Multiply the payroll in col· umn 3 by the "experience rate" in col· umn 5, and enterthe result in CC?lumn 7. 

Column 8.-Subtract the amount in col· umn 7 from the amount in column 6 and 

enter the result in column 8. If zero or less, 

enter zero (0). 

Column 9.-Enter in column 9 the 

amount of contributions actually paid into 

the State fund. 

Line 10.-Enter the sum of columns 8 

and 9. Also include any special credit as explained below. 

line 19.-Show the FUTA wages (if 

any) subject to the un~mployment com· pensation laws of Rhode Island. (If in 

doubt, ask your local IRS office.) Multiply 

the wages by .003. This adjustment is re- quired by Internal Revenue Code· section 

3302(c)(2). If no wages are subject, show 

"none" on line 19. 

Special Credit.-lf you are claiming 

special credit as a successor employer, at· 

tach a statement showing (a) the name, 

address, and employer identification num- ber of your predecessor, (b) how you ac· quired your predecessor's trade or busi· ness (or a separate unit of it), (c) the date 

you acquired it, (d) each item in columns 

1 through 9 that applies to your predeces· 

sor, (e) the number of individuals your 

predecessor employed immediately before 

the acquisition, whom you also employed 

immediately after the acquisition, (f) the 

total remuneration subject to State unem- ployment compensation your predecessor 

paid to the employees in (e) above during 

the calendar year. 

The amount of the special credit is de· 

termined by (1) adding the "Additional 

Credit" and "Contributions actually paid 

to the State" determined for your prede· cessor in step (d) above, and (2) multiplying this total by a fraction of which the 

numerator is the amount determined in 

step (f) above, and the denominator is the 

"Taxable Payroll (as defined in State Act)" 

paid to all individuals in the employ of your 

predecessor prior to your acquisition during the calendar year. 

Computation of 

Taxable FUTA Wages 

Line 11-Total remuneration (including 

exempt remuneration) paid during the cal· 

endar year for services of employees.- Show the total remuneration for services 

you paid employees during the calendar 

year, even if it is not taxable. Include salaries, wages, commissions, fees, bonuses, 

vacation allowances, amounts paid totemporary or part·time employees, and the 

value of goods, lodging, food, and cloth· 

ing. Show the amount before any deduc· 

tions. 

How you pay the remuneration is not 

Important in determining if it is wages. 

Thus, you may pay it for piecework or as a percentage of profits, and you may pay it 

hourly, daily, weekly, monthly, or yearly. 

You may pay it in cash or some other way, 

such as goods, lodging, food, or clothing. 

For items other than cash, use the fair 

value at time of payment. 

Line 12, column (b)-Exempt remu· neration.-"Wages" and "employment" as defined for FUTA purposes do not in· 

elude every payment of remuneration and 

every kind of service an employee may 

perform. In general, remuneration ex· eluded from wages and remuneration for 

services excepted from employment are not included in wages subject to tax. You 

may deduct these payments from total re· muneration paid only if you identify them 

on line 12. 

Show and Identify on line 12 such items as (1) agricultural labor if you paid cash 

wages of less than $20,000 for agricul· 

page 4 

tural labor for each calendar quarter In 

1978, and did not employ 10 or more agri· 

cultural workers during some portion of a day during any 20 different weeks in 1978; 

(2) benefit payments for sickness or in· 

jury under a workmen's compensation 

law, insurance plan, and certain employ~r 

plans; (3) domestic service if you paid 

cash wages of less than $1,000 in each 

calendar quarter in 1978; (4) family ern· ployment; (5) certain fishing activities; 

and (6) any other exempt payments or 

services. For more detailed information, 

see Circular E, Employer's Tax Guide. 

Line 13, column (b).-Show the total 

amount of remuneration you paid each ern· ployee in excess of $6,000. For examPI~ you have 10 employees whom you pal $8,000 each during the year. Sh.ow 1 

$80,000 on line 11 and $20,000 on 1ine 

13, column (b). The $6,000 wage limita· 

tion is for FUTA purposes only. Do not use the State wage limitation for this entry. 

Computation of New 

Jobs Credit Wages 

Column (a).-lf you are eligible for the 

new jobs credit, complete column (a). 

In addition to amounts shown in Un~ 12, column (b), include in line 12, co umn (a) the total amounts paid to an em· 

ployee if: 

(1) services performed by the em; 

ployee during more than one-hair 

of any pay period during the yea are for agricultural labor; or t 

(2) more than one-half of the amo~~e paid to the employee during 

year is for railroad labor; or t 

(3) more than one-half of the amo~~e paid to the employee during ed 

year is not for services perforrn de 

in the United States in the tra or business of the employer. . 

You need not identify these items in~~~ 12; only show the totals in line 12, 

umn (a). 

Line 13, column (a).-Show the to~~ amount of remuneration you paid ea0o 

employee in excess of $4,200. The ~4. 2 

111• limitation is for the new jobs crt:d1~ ction 

putation only. The $6,000 wage 11m1ta nlY· 

in column (b) is for FUTA purp~se.s 0 for 

Do not use the State wage lim1tat1on 

either entry. ·ne if Lines 15a and 15b.-To determ•. bS 

you are eligible to claim the new JO 53 

credit, enter the amounts from line ~it on line 6 of Form 5884, New Jobs er 84; 

and from line 15b on line 1 of Form 58

10y. 

and complete that form. (If your emPer\'' ees perform agricultural or railroad fsorrtl 

ices, see General Instruction D, 

5884.) 
Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $ 300 

FIRST-CLASS MAIL 

POSTAGE & FEES PAID 

TREAS. 

PERMIT No. G-52