Treas. 

HJ 

4653 

.C7A8 

1989 

c.1 

The Operation and Effect 

of the Possessions Corporation 

System of Taxation 

Sixth Report 

Department of the Treasury 

March 1989 

LIBRARY 

ROOM 5030 

APR 11 19t: 1 

TREASURY DEPARTME •t 
The Operation and Effect 

of the Possessions Corporation 

System of Taxation 

Sixth ·Report 

Department of the Treasury 

March 1989 

LIBRARY 

ROOM 5030 

APR 1 1 l9b ~ 

lREASURY DEPARTMENT 
THE SECRETARY OF THE TREASURY 

WASHINGTON 

March 31, 1989 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

U.S. House of Representatives 

Washington, D.C. 20515 

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. 

The Deficit Reduction Act of 1984 specified that the possessions 

report be issued every two years rather than annually. 

Pursuant to these provisions, I hereby submit the sixth 

annual report entitled, The Operation and Effect of the 

Possessions Cor oration S stem of Taxation. This report covers 

tax return in ormat1on 3. 

The Tax Equity and Fiscal Responsibility Act of 1982 

(TEFRA) provided new rules for the allocation of income between a 

U.S. parent corporation and an affiliated possessions 

corporation. This report provides the first evidence on the 

impact of the TEFRA rules. 

I am sending a similar letter to Lloyd Bentsen, Chairman 

of the Senate Finance Committee. 

Sincerely, 

Nicholas F. Brady 

Enclosure 
THE SECRETARY OF THE TREASURY 

WASHINGTON 

March 31, 1989 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

Washington, o.c. 20510 

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. 

The Deficit Reduction Act of 1984 specified that the possessions 

report be issued every two years rather than annually. 

Pursuant to these provisions, I hereby submit the sixth 

annual report entitled, The Operation and Effect of the 

Possessions Corporation System of Taxation. This report covers 

tax return information for 1983. 

The Tax Equity and Fiscal Responsibility Act of 1982 

(TEFRA) provided new rules for the allocation of income between a 

U.S. parent corporation and an affiliated possessions 

corporation. This report provides the first evidence on the 

impact of the TEFRA rules. 

I am sending a similar letter to Dan Rostenkowski, 

Chairman of the Committee on Ways and Means. 

Sincerely, 

Nicholas F. Brady 

Enclosure 
TABLE OF CONTENTS 

List of Tables vi-ix 

Chapter 

1. 

2 . 

3 • 

INTRODUCTION AND SUMMARY 1 

UNITED STATES AND PUERTO RICAN LAW 5 

I. United States Tax Provisions 

A. Historical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 

B. Tax Reform Act of 1976 . • . . • . . . . • . . . . . . . . . . . . . • • • • 6 

C. Tax Equity and Fiscal Responsibility Act of 1982 . 8 

D. Tax Reform Act of 1986 . .. .. . . . . . .. . .. .. . . .. . . . . . . 11 

II. Puerto Rican Tax Provisions . . . . .. .. .. . . . . . . . . .. .. . . . . 12 

A. Taxation of Non-Exempt Corporations . . . . .. . . . . .. .. 12 

B. Taxation Under an Old (1983) Exemption Grant ..... 13 

C. Taxation Under an Old Exemption Grant "Converted" 

to the 1978 Industrial Incentives Act ...... ... ... 13 

D. Taxation of Companies with an Exemption Grant 

Under the 1978 Industrial Incentives Act ......... 14 

ECONOMIC DEVELOPMENT IN PUERTO RICO 17 

I. Growth Since 1948 17 

II. Investment in Puerto Rico . . . . . . . . . .. . . . . . . . . .. . . . .. . . 22 

A. Overall Investment............................... 22 

B. Industry Composition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 

4. CHARACTERISTICS OF POSSESSIONS CORPORATIONS AND REVENUE 

EFFECT OF SECTION 936 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 

I. Assets and Income in Tax Year 1983 . . . . ... . . .... ... .. . 32 

A. Asset Composition of Puerto Rican Investment ..... 32 

B. Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 

C. Total Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 

D. Net Taxable Income per Tax Return ............... 40 

E. Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 

II. Estimated Tax Benefits in Tax Year 1983 44 

III. Payroll and Employment in Tax Year 1983 46 

IV. Summary Data for 1974-1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 

V. Estimates of Linkages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 

A. Forward Linkages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 

B. Backward Linkages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 

C. Consumption-Related Linkages . . . . . . . . . . . . . . . . . . . . . 56 

-v-
TABLE OF CONTENTS 

VI. Revenue Impact of Se.ct ion 936 . . . . . . . . . . . . . . . . . . . . . . . . 57 

A. Revenue Estimates and Estimating Procedure ....... 57 

B. Alternative Tax-saving Routes .... .. . ... . ...... ... 57 

S. IMPACT OF 936 FINANCIAL ASSETS ON PUERTO RICO GROYTH -

6 . 

RECENT DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 

II. The 

A. 

B. 

c. 

D. 

Data 

Frequencies By Method of Filing ................. . Frequencies by Industry ......................... . The Benefit and Employment Information, By Method 

Tax Benefit and Employment Information, By 

Industry ................................... , .... . 

III. Analysis ............................................ : 

THE IMPACT OF 936 FINANCIAL ASSETS ON PUERTO RICAN 

INVESTMENT - RECENT DEVELOPMENTS ......................... . 

62 

62 

62 

64 

66 

66 ~ 

7 3 \ -

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 

II. Recent Regulatory and Statutory Changes . . . . . . . . . . . . . . 73 

A. The April 17, 1984 Regulation .......... ..... ..... 75 

B. The Tax Reform Act of 1986 ...•................... 75 

C. Brief Summary of Regulation 3582 ••• ••. • ••• ••••••• 76 

III. Net C~pi al Inflows Into Puerto Rico 936 Funds ....... 77 

IV. Eligible ·Assets and the Interest Rate on 936 Funds ... 81 

v . c 0 n c 1 us i 0 n .-. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 5 

J. 

APPENDICES 

A. OPERATION OF THE POSSESSIONS CORPORATION SYSTEM OF TAXATION 

IN AMERICAN SAMOA, GUAM, THE COMMONYEALTH OF THE NORTHERN 

( 

MARIANAS AND THE VIRGIN ISLANDS . ............... ............ 87 

I'. American Samoa and Guam............................... 88 

II. , Virgin Islands ........................... ............ . 

A. Taxation of Corporations Operating in the Virgin 

Islands ......................................... . 

89 

89 

B. Taxation of Dividends Received from Corporations 

Operating in the Virgin Islands . . . . . . . . .. . . . . . . . . . 91 

C. Allocation of Income Attributable to Intangibles . 93 

D. Characteristics of Corporations, Partnerships, and 

Sole Proprietorships Eligible for Virgin Islands 

Tax Rebates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 

-vi-
TABLE OF CONTENTS 

Page 

B. POSSESSIONS CORPORATIONS IN TAX YEAR 1982 .................. 97 

I. Assets and Income in 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 

A. Assets • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 97 

B. Retained Earnings . . . . . . . . . . . . . . . . . . . . . . • . . . . . . . . . 101 

C. Total Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . • . 101 

D. Net Income per Tax Return ..•........•.•..•....... 101 

E. Reduction in U.S. Tax Liability •..•.••.......•... 101 

F. Distributions .............................. ~...... 101 

II. Payroll and Employment in 1981 - ....................... 101 

C. SOURCES AND LIMITATIONS OF THE DATA ON POSSESSIONS 

CORPORATIONS • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 107 

I • C o v e r a g e • • • • • • • • • • • ....... • • ,.; • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 1 0 7 

II. Income Statement and Balance Sheet Data .............. 107 

III. Employment and Payroll Data .......................... 107 

D. TAX FORMS FROM VHICH DATA INCLUDED IN THIS REPORT VERE 

OBTAINED . . . . . . • . . . . . . . . . . . . . . . . . . . . . • . . . . . . . . • . . . . . . . . . . . . . 109 

Tables 

3-1 TOTAL AND PER CAPITA GROSS NATIONAL PRODUCT OF PUERTO 

RICO, 1947-1988 . . . . . . . . . . • . . • . . • • . • • . . • • • • • . • • • . • • • . . . . 18 

3-2 

3-3 

~ NET MIGRATION OF RESIDENTS O'F PUERTO RICO ......••...... 

( 

PUERTO RICAN UNEMPLOYMENT RATE AND DISTRIBUTION OF 

EMPLOYMENT IN SELECTED YEARS, 1950-1988 .•.............. 

3-4 NET FEDERAL PAYMENTS TO PUERTO RICO, SELECTED FISCAL 

20 

21 

YEARS 1968-1986 . . • . . • • • . . . . . . . . . . • . • . . . . . . • . . • • • . . . • . . . 23 

3-5 

3-6 

COMPONENTS OF REAL FIXED INVESTMENT IN PUERTO RICO, 

FISCAL YEARS 1960-1988 ...•........•.....•.............. 

NET INCOME ORIGINATING IN PUERTO RICAN MANUFACTURING, 

FISCAL YEARS 1960, 1970, 1980, AND 1983 AND 1988 ..•..•. 

25 

28 

4-1 SELECTED BALANCE SHEET INFORMATION BY INDUSTRY, 1983 ... 33-35 

4-2 NET PLANT, EQUIPMENT AND PROPERTY AS A PERCENTAGE OF 

TOTAL ASSETS FOR POSSESSIONS CORPORATIONS AND 

CORPORATIONS OPERATING IN THE U.S., 1983 .............. . 

-vii37 
TABT.E OF CONTENTS 

4-3 BEFORE-TAX OPERATING INCOME AS A PERCENT OF OPERATING 

ASSETS FOR POSSESSIONS CORPORATIONS NOT ELECTING PROFITSPLIT METHOD AND CORPORATIONS OPERATING IN THE U.S. 

198 3 .................................................. . 

4-4 SELECTED INCOME STATEMENT INFORMATION BY INDUSTRY FOR 

FOR COMPANIES NOT ELECTING PROFIT METHOD, 1983 ....... . 

4-5 NET INCOME, POSSESSIONS TAX CREDITS CLAIMED AND 

ESTIMATED TAX BENEFITS BY INDUSTRY, 1983 .............. . 

4-6 TAX BENEFITS PER EMPLOYEE AND AS A PERCENT OF COMPENSATION BY INDUSTRY, 1983 .............................. . 

4-7 DISTRIBUTIO~ OF TAX BENEFITS AND EMPLOYMENT BY INDUSTRY, 

1 9 8 3 .................................................. . 

4-8 TAX BENEFITS, EMPLOYMENT, AND COMPENSATION OF EMPLOYEES 

BY SIZE OF TAX BENEFITS PER EMPLOYEE, 1983 ............ . 

4-9 SUMMARY DATA ON POSSESSIONS CORPORATIONS, 1974-1983 ... . 

4-10 DESTINATION OF SHIPMENTS BY PUERTO RICAN MANUFACTURING 

INDUSTRIES, 1977 AND 1982 ............................. . 

4- 11 FEDERAL REVENUE COST ESTIMATES, POSSESSIONS CORPORATION 

PROVISIONS, 1973-1983 ................................. . 

5-1 FREQUENCIES BY METHOD OF FILING ..................... •'•. 

5-2 FREQUENCIES BY METHOD OF FILING, BY INDUSTRY, ALL 1983 

FIRMS ................................................. . 

5-3 PERCENTAGES BY INDUSTRY FOR EACH FILING CATEGORY 

ALL 1983 FIRMS ........................................ . 

5-4 TAX BENEFIT AND EMPLOYMENT INFORMATION FOR MATCHED 

FIRMS, BY METHOD ...................................... . 

5-5 TAX BENEFIT AND EMPLOYMENT INFORMATION FOR MATCHED 

FIRMS, BY INDUSTRY .................................... . 

5 - 6 TAX BENEFIT INFORMATION FOR MATCHED ELIGIBLE FIRMS 

BY INDUSTRY ........................................... . 

6-1 ESTIMATED COMPOSITION OF THE FINANCIAL INVESTMENTS 

OF POSSESSIONS CORPORATIONS AT YEAR-END 1986 .......... . 

6- 2 COMPONENTS OF THE PUERTO RICO CAPITAL ACCOUNT, 1974-1986 

-viii38 

41-43 

45 

47 

49 

50 

52 

54 

58 

63 

65 

67 

68 

" 69 

70 

74 

78 
TABLE OF CONTENTS 

6-3 ANNUAL GROSS DOMESTIC INVESTMENT IN PUERTO RICO, 1973-

1988 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 

6-4 936 FUNDS AND ELIGIBLE ACTIVITIES OF ALL COMMERCIAL AND 

SAVINGS BANKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 

6-5 

A-1 

936 INTEREST RATES VS. OTHER SHORT TERM RATES ......... . 

934(B) CORPORATIONS IN THE VIRGIN ISLANDS - SELECTED 

BALANCE SHEET AND INCOME STATEMENT ITEMS AND TAX BENEFITS BY TYPE OF CORPORATION, 1983 ..................... . 

84 

95 

B-1 SELECTED BALANCE SHEET INFORMATION BY INDUSTRY, 1982 .. 98-100 

B-2 SELECTED INCOME STATEMENT INFORMATION AND TAX BENEFITS 

BY INDUSTRY, 1982 ................................... 101-104 

B-3 TAX BENEFITS, EMPLOYMENT, AND COMPENSATION OF EMPLOYEES 

BY INDUSTRY, 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 

-ix-
Chapter I 

INTRODUCTION AND SUMMARY 

This is the sixth report to the U.S. Congress on the possessions corporation system of 

taxation. Possessions corporations, also known as 936 corporations, are U .S.-chartered 

companies1 that are effectively exempt under section 936 of the Internal Revenue Code2 from 

Federal tax on business income and qualified passive investment income from Puerto Rico and 

certain other U.S. possessions. Almost all possessions corporations operate in Puerto Rico. 

Data used in the report include tax return info1mation for possessions corporations filing 

tax returns for calendar year 1983 or for a fiscal year ending after June 30, 1983. and on 

or before June 30, 1984. (Most economic data other than from tax returns cover years 

through 1988.) The analysis reflects the amendments to section 936 made by the Tax Equity 

and Fiscal Responsibility Act of 1982 (TEFRA). Changes made by the Tax Reform Act of 1986 

are also noted. However, the Puerto Rican Incentives Act of 1987 and Regulation 3582. 

governing financial assets, will not be reviewed in detail until the next Possessions 

report. 

The requirement to produce possessions reports was created by the Tax Reform Act of 1976. 

The legislative history to the provision contained the following guidance: 

It is the understanding of the committee that the Department of Treasury is to 

review operation of section 936 corporations in order to appraise the committee of 

the effects of the changes made by the bill. 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. Among other things, the report is to 

include an analysis of the revenue effects of the provision as well as the effects 

on investment and employment in the possessions. (S. Rept. 94-938, p. 282; also H. 

Rept. 94-658 p. 259). 

Chapter 2 of the report summarizes U.S. and Puerto Rican legislation concerning possessions corporations, including the modifications to U.S. law introduced in TEFRA. TEFRA 

provided special rules for the allocation to a possessions corporation of income from 

patents, trademarks, and other intangibles. These amendments reflect Congressional concern 

that corporations operating in the United States were shifting substantial income from 

intangibles to their section 936 subsidiaries in order to increase the tax savings provided 

under section 936. Because the TEFRA provisions were implemented for taxable years 

beginning after 1982, this repo11 is the first to include post-TEFRA tax data. 

1 Although Puerto Rico and other U.S. possessions are included in some definitions of the United States. the term 

"United States" in this report includes only the fifty states and the District of Columbia. 

2 Unless otherwise indicated. all section references are to the Internal Revenue Code of 1986. as amended (the 

"Code "). 

-1-
-2-

Chapter 3 surveys Pnerto Rican economic growth since 1948 and the impact of U.S. and 

Puerto Rican tax exemptions in shaping that growth. The tax exemptions contributed to a 

shift in the basis of the economy from agriculture in the 1950s to manufacturing, services, 

trade. and government in the 1970s. The effect of low wages relative to the United States 

and exemption from U.S. tariffs probably also contributed to the sustained high rate of 

Puerto Rican industrialization and economic growth in the 1948-1972 period. Puerto Rican 

real gross national product (GNP) grew at an average annual rate of six percent, and real 

GNP per capita grew by five percent per year. The most important sector of growth was 

manufacturing, where employment rose from 55,000 in 1950 to 142,000 in 1972. 

After 1972, however, Puerto Rican economic progress slowed and only in 1987 and 1988 did 

this rate of growth approach the levels of the pre-1972 period. The economy was badly hurt 

by the U.S. recessions of 1974-75 and 1981-82. Increases in Puerto Rican wages and cuts in 

U.S. tariffs reduced Puerto Rico·s ability to compete with foreign locations as a site for 

U.S. investment. Employment in manufacturing was relatively stagnant in the period 1972-83 

despite an expansion of jobs in high-technology industries such as pharmaceuticals and 

electronics. After recovering from the 1982-1983 recession, manufacturing employment was 

flat in 1985 and 1986 but then grew to new peak levels in 1987 and 1988. Employment in 

construction also increased strongly in 1987 and 1988. 

In constant dollars. private investment in plant and equipment declined in the ten years 

after 1973, so that its level in 1983 was about half of its level ten years earlier. 3 The 

Puerto Rican economy was in recession in the two-year period ending in June 1983. With the 

resumption of growth in the U.S. economy in 1983, Puerto Rican growth also resumed. Private 

fixed investment began to recover, and by 1988 was in real terms almost at the peak levels 

of the early 1970s. The unemployment rate reached an all-time annual high of 23.4 percent 

in the year ending June 1983, but declined slightly from 1983 to 1986. In 1987 and 1988, 

the drop in the unemployment rate accelerated. Jn September J 988, it stood at 14.4 percent. 

This improvement reflected the growth of real GNP by 5.0 percent per year in 1987 and 1988. 

Chapter 4 describes the characteristics, by industry, of possessions corporations. It 

presents data for tax year 1983 on assets, income, tax benefits, employment, and payroll. 

In 1983, there were 527 possessions corporations engaged in manufacturing; they earned net 

income of $4. l billion and derived tax benefits of $1.6 biHion. The average ratio of 

operating income to operating assets for the companies not electing the profit-split method 

of income allocation under TEFRA (accounting for 80 percent of all assets of 936 corporations) was more than five times that ratio for all mainland manufacturing companies. 

3 

Although private refinery construction represented 30 percent of total private investment in Puerto Rican plant and 

equipment in the period I 970-72, it had dropped to 4 percent in I 973 and remained at approximately that level 

during most subsequent years. The short-lived boom of the Puerto Rican petrochemical industry was based on 

Puerto Rico's large allocation of U.S. oil import quotas for foreign oil (which before 1973 was cheaper than 

domestic oil). 
-3-

By enacting section 936. Congress sought to assist Pnerto Rico in ohtnining employmentproducing investments. Matching income tax return information with Federal unemployment 

insurance tax returns for individual section 936 corporations indicates the extent to which 

this objective has been realized. Based on the sample of corporations for which employment 

information is available, employment in all possessions corporations in manufacturing 

industries is estimated to be 88,579 persons, which represents 12 percent of total 

employment in Puerto Rico and 62 percent of employees in Puerto Rico's manufacturing sector 

in 1983. 

Possessions corporations' U.S. tax benefits in relation to their employment vary 

substantially by industry. In 1983, tax benefits per employee averaged $57,761 in the 

pharmaceutical industry and $3,000 to $4,000 in the low-technology, labor-intensive 

industries. Over all manufacturing industries, possessions corporations' tax benefits 

averaged $18,523 per employee, or 125 percent of the average compensation per employee. 

This represents a decline from tax benefits per employee of $20,699 in 1982, or 148 percent 

of compensation. While this report does not make any attempt to estimate the impact of the 

Tax Reform Act of 1986 (TRA), the tax benefits of section 936 can be expected to be lower 

than if pre-TRA law had been in effect because of the large decrease in the statutory 

corporate tax rate and other provisions. 

Chapter 4 also presents summary data for the period 1974 through 1983. Net income of 

possessions corporations in the manufacturing sector rose from about $800 million in 1974 to 

$4 billion in 1983. The percentage of total net income of manufacturing possessions 

corporations earned by the pharmaceutical industry was 40 to 50 percent through the period 

1974-1981, 54 percent in 1982, and 29 percent in 1983. The share of net income earned by 

the electrical and electronics industry varied between 15 percent and 20 percent in most 

years. except 1981 and 1983, when the respective percentages were 26 and 24. 

Chapter 5 explores th"' effect of the TEFRA legislation on the credits that possessions 

corporations took and the ratio of tax benefits to employee compensation. Conclusions are 

tentative. because not all possessions corporations in the 198:; data set were eligible for 

the TEFRA changes, not all that were eligible reported accurately under the new law, and not 

an relevant data were collected. With these caveats in mind, one can nevertheless 

speculate that the legislation was somewhat effective. In a group of firms with matched 

1982 and 1983 tax returns that were required to use the TEFRA rules, accounting for 73 

percent of all 1983 possessions credits, tax benefits declined from 13 7 percent of 

compensation in 1982 to 101 percent in 1983. In contrast, tax benefits received by 

companies not required to use the TEFRA provisions increased substantially. 

Possessions corporations held approximately $15 billion in Puerto Rican financial assets 

a of year-end 1986. Chapter 6 analyzes the impact of these assets on Puerto Rican growth. 

It first reviews recent regulatory changes by the Puerto Rican government in its continuing 

effort to channel section 936 financial assets to productive uses in Puerto Rico. The 

chapter then attempts to evaluate the impact of financial investments by section 936 

corporations on interest rates, capital inflows, and real investment in Puerto Rico. It 
-4-

concludes that is very difficult to identify any significant reduction in interest rates or 

increase in real investment as a result of 936 funds. WhiJe private real fixed investment 

has recovered in recent years, in 1988 it was still below the peak levels reached in the 

early 1970s before the enactment of the Qualified Possession Source Investment Income 

Provision (QPSII) in section 936. 

Appendix A describes the operation of the possessions corporation system of taxation in 

American Samoa, Guam, and the Virgin Islands. 

Appendix B reports the assets, income, and tax benefits of possessions corporations in 

Puerto Rico in tax year 1982. 

Appendix C discusses the sources and limitations of the data used in the report. 

Appendix D contains copies of the tax forms from which the data were obtained. 
Chapter 2 

UNITED STATES AND PUERTO RICAN LAW 

The possessions corporation system of taxation is a set of rules under which a U.S. 

corporation deriving qualifying income from possessions and Pue110 Rico pays no income tax 

to the United States. As a U.S. corporation, a possessions 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 and from 

qualified possession source investment income (QPSII). A U.S. parent corporation can. in 

tum. offset dividends received from a wholly owned 936 subsidiary with a JOO percent 

dividends-received deduction, which frees the dividend income from federal tax.

1 Not only 

is no federal tax assessed, possessions corporations in manufacturing industries currently 

pay an average of only approximately 5 percent of the income in taxes to Puerto Rico. 

Puerto Rico has primary taxing jurisdiction over Puerto-Rican-source income~ the United 

Sta'.es has secondary taxing jurisdiction over Puerto-Rican-source income of U.S. 

corporations, citizens, and residents. Because the Puerto Rican rules have been fashioned 

to take advantage of the federal rules and have changed with the federal rules. however. the 

federal rules are described first. 

I. United States Tax Provisions 

A. Historical Background 

The main elements of the possessions corporation tax exemption became part of U.S. law as 

section 262 of the Revenue Act of 1921. These provisions were adopted primarily to help 

U.S. corporations compete with foreign firms in the PhiHppines (which was a U.S. possession 

before 1946). Under these provisions, U.S. corporations that met two gross income tests 

were exempt from tax on all income derived from sources outside the United States. To 

qualify for the exemption, a U.S. corporation had to derive 80 percent or more of its gross 

income from the possessions and 50 percent or more of its gross income from the active 

conduct of a trade or business in the possessions. These gross income tests had to be 

satisfied in the tax year in which the exemption was claimed and in the two preceding tax 

years if the corporation had conducted a trade or business in a possession during that 

period. A corporation that met the 80-50 income tests was commonly known as a "possessions 

corporation." Such a corporation was usually organized as a special-purpose subsidiary of a 

U.S. parent company in order to ensure that the tests were met. Under the I 921 Act. dividends paid by a possessions corporation to a corporate shareholder were fully taxable. 

1 The dividend may be subject to tax under the book income provision in the Alternative Minimum Tax enacted 

in the Tax Reform Act of 1986. 

-5-
-6-

Therefore. a U.S. corporate shareholder could defer U.S. tax on the foreign-source income of 

a possessions corporation (from both within and without the possessions) until it was 

repatriated. 2 Liquidation would result in no U.S. tax because of section 332 and this 

became the major vehicle for repatriations. 

B. Tax Reform Act of 1976 

The possessions corporation exemption remained unchanged until the Tax Reform Act of 

1976. Many U.S. firms established plants in Puerto Rico after 1948. when Pue110 Rico 

enacted a program of tax exemption for manufactuting firms. Before the .. 1976 Act was 

implemented. proponents of continued U.S. tax exemption argued that the possessions 

corporation system of taxation was needed to offset the U.S. minimum wage requirement. the 

requirement to use U.S. flag vessels in transporting goods to the United States. and other 

Federally imposed requirements that tended to reduce Puerto Rico·s ability to compete with 

neighboring countries for U.S. investment. 

By enacting the Tax Reform Act of 1976, Congress wanted to leave undisturbed the tax 

exemption of earnings from a trade or business in Puerto Rico or from investments made with 

those earnings for Puerto Rican use. At the same time. Congress wished to end the exemption 

for passive income from funds invested in foreign capital markets and to hasten their 

repatriation if not used in the possession. Congress stated that it sought to 

assist the U.S. possessions in obtaining employment-producing investments hy U.S. 

corporations. while at the same time encouraging those corporations to bring back to the 

United States the earnings from these investments to the extent they cannot be reinvested 

productively in the possession. 3 

To continue promoting Puerto Rico ·s industrial development. the Tax Reform Act of 1976 

therefore left intact the exemption for income derived by U.S. corporations from operations 

in a possession. It also exempted from tax the dividends remitted by a possessions 

corporation to its U.S. parent. To prevent the avoidance of tax on income invested in 

foreign countries by possessions corporations. however, the Tax Reform Act eliminated the 

exemption for income derived outside the possessions. The changes in the tax treatment of 

possessions corporations were effected by removing possessions corporations from section 931 

of the Internal Revenue Code and placing them into a newly created Code section 936. The 

differences between sections 931 and 936 are: 

2 

3 

Foreign-chartered corporations also benefit from the deferral of U.S. tax on foreign-source income until profits 

are remitted to the United States. However. in the first part of this century U.S. companies did not generally 

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. 

Report of the Committee on Wavs and Means. U.S. House of Representatives. on H.R. 10612. Report No. 94-658. 

November 12. 1975. p. 255: and Report of the Committee on Finance. United States Senate. on H.R. 10612. 

Report No. 94-938. June 10. 1976. p. 279. 
4 

5 

' 

-7-

o Change in the scope of and method of effecting the tax exemption. Before 1976. a 

possessions corporation was exempt from U.S. tax on all income derived from sources 

outside the United States. Under the Tax Refonn Act of 1976. the exemption was 

limited to two kinds of income: 

Income from the active conduct of a trade or business in a possession. or from 

the sale or exchange of substantially all of the assets used by the corporation 

in the active conduct of such trade or business; and 

QPSII. which is non-business income derived from the possession in which the 

corporation has its trade or business 4 and which is attributable to the investment of funds derived from such trade or business for use within the possession. 

Rather than exempting the income from U.S. taxation. section 936 provides a credit 

equal to (and. therefore. fully offsetting) the U.S. tax on the income. The section 

936 credit is not available for other income earned by a possessions corporation. 

However. a regular foreign tax credit may be claimed for foreign (including 

possession) taxes paid or accrued with respect to income that does not qualify for 

the 936 credit. 

o Exemption from U.S. tax on dividends remitted by a possessions corporation to its 

U.S. parent. Before 1976. dividends paid by a possessions corporation to its U.S. 

parent were fully taxable to the U.S. parent. but amounts received upon liquidation 

of a possessions corporation were tax-exempt. As a consequence. 931 corporations 

accumulated substantial earnings and invested them in the Eurodollar market in 

anticipation of a tax-free liquidation. 5 To accelerate the repatriation of earnings 

and to remove the tax incentive to liquidate. the Tax Refonn Act of 1976 allowed U.S. 

parent corporations to claim a dividends-received deduction for dividends from an 

affiliated possessions corporation. If the possessions company was a wholly owned 

subsidiary (as most were and continue to be). the deduction equaled 100 percent of 

the dividend so the dividend was free of any U.S. tax. 

o Requirement that a possessions corporation elect the benefits of section 936 for ten 

years. Under section 931, as construed by the courts.

8 

a possessions corporation 

The requirement that QPSII 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. say. a Guamanian bank. 

This practice was popular under section 931 (before 1976). 

Possessions companies were not generally subject to the U.S. accumulated earnings tax. 

Burke Concrete Accessories. Inc .. et al. v. Commissioner of Internal Revenue. 56 Tax Ct. 588 ( 1971 ). This 

case overturned Rev. Rul. 65-293. 1965-2 C.B. 323. 
-8-

which suffered a loss in a given year could join its parent and other affiliated corporations in filing a consolidated return for such year. For years in which the 931 

corporation had income. it filed separately to receive 931 benefits. The parent of a 

931 corporation thus avoided taxes on the 931 corporation ·s profit but could offset 

the 931 corporation ·s losses against other taxable income. Under section 936. a 

possessions corporation can elect the benefits of section 936. with the election 

being irrevocable for ten years. During the ten years it cannot join with its parent 

in filing a consolidated return. although it can delay electing 936 status until it 

shows a profit. 

C. Tax Equity and Fiscal Responsibility Act of 1982 

I . Treatment of Income from Intangibles 

Before 1982. there were no explicit statutory guidelines on the allocation to a 

possessions corporation of income from intangibles (such as patents. trademarks. and 

trade names) which had typically been developed and paid for by an affiliated U.S. 

corporation and subsequently transferred to the possessions corporation. In many instances. 

U.S. corporations attempted to increase the income that was exempt from tax under section 

931 or 936 by transfen-ing to an affiliated possessions corporation such income-producing 

intangible assets. These corporations interpreted the law as requiring no allocation of 

income generated by the intangibles to the U.S. parent. For example. a pharmaceutical 

company might develop a patentable drug in its U.S. laboratory and transfer the patent to 

its wholly owned possessions corporation. The possessions corporation would produce. in 

whole or in part. the patented drug and would claim the income from the patent as possession-source gross income. As a result. the parent would obtain deductions for the research 

and development that gave rise to the patent. while the 936 company would realize tax-free 

income. The view of the Internal Revenue Service. however. is that income generated by the 

transferred intangibles must be allocated to the U.S. parent corporations. 7 This issue has 

resulted in lengthy litigation.' 

In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Congress provided 

statutory rules for the allocation to a possessions corporation of income from intangibles. 

The purpose of these provisions was "to lessen the abuse caused by taxpayers claiming 

tax-free income generated by intangibles developed outside of Puerto Rico. "

9 

TEFRA added a 

new section 936(h) to the Internal Revenue Code. which provides that income from intangibles 

7 

• 

9 

For a description of the prc-1982 rules relating to intercorporate transfers of assets and the allocation of 

income . sec pages 14-20 of The Operation and Effect of the Possessions Corporation System of Taxation. Fourth 

Report. U.S. Treasury Department. February. 1983 . 

See. for example. Eli Lilly and Co. v. Commissioner. 84 T.C. no. 65 (May 28. 1985): affd in part and rev 'd in 

part. 856 F.2d 855 (7th Cir. 1988). 

Joint Committee on Ta,c;ation. General Explanation of the Revenue Provisions of the Tax Equity and Fiscal 

ResponsibiJitv Act of 1982. December 1982. pp. 81-83 . 
-9-

is generally taxable to the U.S. shareholders of the possessions corporation. TEFRA also 

provided that a possessions corporation and its affiliates could elect out of the general 

rule under either a "cost-sharing" option or a "50150 profit-split" option. The options 

provide a framework within which a possessions corporation may claim certain income from 

intangibles developed or purchased by its affiliated corporations. These options apply to 

the products produced in whole or in part by a possessions corporation (so-called 

"possession products"). Regulations issued by the Treasury Department under section 

936(h)10 provide rules for the computation of income from the "possession product." 

including cases where the product is not sold directly to foreign affiliates or unrelated 

persons but is a component of. or one stage of processing in. a product sold to unrelated 

persons. 

a. Eligibility 

To be eligihle to use the cost-sharing or profit-split option to compute income from a 

possession product, a possessions corporation must have a "significant husiness presence" 

with respect to that product in a possession. This requirement is met if the possessions 

corporat ·on meets one of two tests: 

o 25 % value-added test. The possessions corporation must show that it incurred 

production costs (other than the cost of materials and interest excluded by 

regulation) with respect to the product that are not less than 25 percent of the 

difference between (a) gross receipts from sales or other dispositions of the product 

to unrelated parties by the possessions corporation or its affi ti ates. and ( b) direct 

costs of materials purchased by the possessions corporation or its affiliates from 

unrelated parties in connection with the manufacture of the product. This test is 

equivalent to a 25 percent value-added requirement. 

o 65 % labor test. Alternatively. the possessions corporation must show that it 

incurred at least 65 percent of the total direct labor costs of the possessions 

corporation and its affiliates in producing a product or service during the taxable 

year. The 65 percent must be compensation for labor services performed in the • 11 possession. 

Start-up operations of new 936 corporations and new possession products of existing 936 

corporations can meet the "significant business presence" requirement by satisfying a lower 

threshold of value-added or labor cost than the percentages referred to above. For such 

operations. the applicable percentages under the regulations are as follows: 

10 Proposed regulations appeared in the Federal Register on January IO. 1984 (pp. 1.227-1.243) and were 

finalized by T.D. 8090 on July 7. 1986. 

11 The "product area" is defined by reference to the 3-digit classification of the Standard Industrial Classification 

code. Examples of 3-digit codes are drugs. electronic components. and beverages. 
- I 0-

Business presence tests for Year 

start-up operations 2 3 

Value-added test 10% 15% 20% 

Labor test 35% 45% 55% 

b. Cost-Sharing Option 

Under the cost-sharing option. a possessions corporation is required to ma-ke a payment to 

its U.S. parent. The payment equals a fraction of rhe current year· s research expenditures 

of the affiliated group in the "product area" in which the possession product falls. 12 The 

fraction equals the ratio of third-party sales of the possession product made by the 

affiliated group to third-party sales of all products in the product area made by the 

affiliated group. The cost-sharing payment therefore reduces the amount of deductions 

allowable for U.S. affiliates. 

The cost-sharing payment is the quid pro quo that allows the possessions corporation to 

he treated as the owner of the manufacturing intangibles (but not marketing intangibles) 

associated with the possession product. Therefore. a determination must be made under the 

cost-sharing option as to what portion of the final sales price of the possession product is 

a return to manufacturing intangibles (and is therefore tax-exempt income to the possessions 

corporation) and what portion is a return to marketing intangibles (and is therefore taxahle 

income to the affiliates that perform the marketing). Section 482 regulations are intended 

to be applied in making this determination. 

c. 50150 Split of Combined Taxable Income from the Possession Product 

Under the profit-split option. 50 percent of the comhined taxable income of the 

possessions corporation and its U.S. affiliates that is derived from sales of the possession 

product to foreign affiliates or unrelated persons is allocated to the possessions 

corporation. The remainder is generally allocated to U.S. affiliates. This option pennits 

the possessions corporation to obtain part of the return on all intangibles related to the 

possession product. For purposes of computing the combined taxable income from the product. 

all direct and indirect expenses relating to the product are taken into account. 

The regulations under section 936(h) provide a flexible definition of the tenn 

"possession product." The term includes any item of property which is the result of a 

production process. including components and so-called "end-product forms." (End-product 

12 As a variant of this test. the regulations under current section 936(h) permit certain Puerto Rican construction 

costs rather than labor costs to be used to meet the business presence requirement. 
- l l -

forms are products that are treated as not including certain of their components for 

purposes of the business presence test and the computation of income from the poc;session 

product.) 

2. Passive Income Limitation under TEFRA 

In addition to the new guidelines on income from intangibles. TEFRA raised from 50 to 65 

percent the qualifying share of the gross income that a corporation must derive from the 

active conduct of a possessions trade or business to be eligible for the 936 credit. This 

increase was phased in so that the p~rcentage rose to 55 percent for taxable years beginning 

in I 983. and to 60 percent for taxable years beginning in 1984. As under prior law. the 

gross income test must have been met for the three-year period immediately preceding the 

close of the taxable year (or for such part of such period as was applicable). The greater 

level of required business activity means that proportionately less passive investment 

income could have been earned by a corporation still wishing to qualify for effective tax 

exemption under section 936. 

D. Tax Reform Act of 1986 

The Tax Reform Act of 1986 makes several adjustments to the possessions tax credit. 

These include the following: (I) the cost-sharing payment equals the greater of l I 0 percent 

of the payment required under prior law or the royalty payment that would be required with 

respect to manufacturing intangibles if the possessions corporation were a foreign corporation (see sections 482 and 367(b)). (2) the amount of product area research expenditures is 

increased by 20 percent over the amount required under prior law for purposes of computing 

combined taxable income under the profit-split method. (3) the passive income limitation is 

reduced from 35 percent to 25 percent. and (4) QPSII is expanded to include income 

attrihutable to loans made by the Government Development Bank for Puerto Rico and other 

financial institutions for the acquisition or constnaction of active business assets or for 

development projects in qualified Caribbean Basin Initiative (CBI) countries. 13 Although no 

amount of CBI fund commitment is specified. Puerto Rico is expected to demonstrate a good 

faith effort to implement a program · to encourage companies to develop or expand 

manufacturing operations in qualified CBI countries. 

13 On August 6. 1983. President Reagan signed legislation containing the "Caribbean Basin Economic Recovery 

Act." commonly known as the Caribbean Basin Initiative (CBI). The legislation enables U.S. taxpayers to 

deduct expenses for conventions held in the eligible countries. provided that such countries enter into a ta~ 

information exchange agreement with the U.S. The potentially eligible countries are the twenty-one Caribbean 

jurisdictions and Bermuda. The first country to take ad\'antage· of the CBI benefits was Barbados: other 

countries currently qualifying are Grenada. Jamaica. and Dominica. 
-12-

II. Puerto Rican Tax Provisions 

Since 1948, Puerto Rico generally has provided its own tax incentives for manufacturing 

and other specified business activities.14 Puerto Rico currently grants partial exemptions 

from income tax and other taxes to approved businesses for specified periods of time 

(usually ten to twenty-five years). Possessions corporations in the manufacturing sector in 

Puerto Rico nonnal1y hold an exemption contract from the Puerto Rican government. In J 983 

such corporations paid, on average, an estimated 5 percent of their income in taxes to 

Puerto Rico. The following paragraphs describe the Puerto Rican Industrial Incentives Act 

of 1978 including a discussion of Puerto Rican taxation of non-exempt corporations. taxation 

under an old (pre- J 978) exemption contract. taxation under a "converted" exemption contract. 

and taxation under a new exemption contract. The Puerto Rican Tax Incentives Act of 1987 

will be reviewed in the next Possessions report. 

A. Taxation of Non-Exempt Corporations 

Puerto Rico ·s authority to enact its own income tax system comes from the Organic Act of 

1917 (the Jones Act). In 1954, the Puerto Rican legislature adopted its present income tax 

system. which is 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 residents and Puerto 

Rican corporations. Corporate income tax rates before 1987 were 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 similar to those specified in the U.S. 

Internal Revenue Code. (Under changes in the Puerto Rican tax code enacted in 1987. the new 

marginal tax rates range from 22 percent to 39 percent.) However. the Puerto Rican code 

contains a "flexible depreciation" provision. This provision permits taxpayers to recover 

the cost of "qualifying property" in any taxable year or years chosen by the taxpayer. up to 

a limit of 50 percent of net income. without regard to the useful life of the property. 

Generally. property acquired for use in agriculture. construction. manufacturing. hotels. or 

shipping qualifies for flexible depreciation. 

In addition to its income tax, Puerto Rico imposes a "tollgate tax" on dividends paid out 

of Puerto-Rican-source earnings and profits to a U.S. or foreign parent corporation. If the 

parent corporation is not engaged in a trade or business in Puerto Rico. the dividend is 

subject to a 25 percent tollgate tax withheld at source. However. the rate of tollgate tax 

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

a hotel. manufacturing. or shipping business. The tax is reduced further. to 5 percent. if 

the Puerto Rican company retains a specified percentage of its profits. 

14 Pages 23-25 of the Fourth Report summarize the history of the Puerto Rican Industrial Incentives Act. 
- I 3-

B. Taxation Under an Old (1963) Exemption Grant 

In general, a firm that has a tax-exemption grant under the l 963 Industrial Incentive Act 

is 100-percent exempt from tax on business income and on investment income from certain 

designated assets.

15 This tax-exempt income is called Industrial Development Income. The 

finn is also I 00-percent exempt from property and gross receipts taxes. The tax-exemption 

grant lasts from ten to thirty years. depending on the location of the plant. 

Dividends paid from Industrial Development Income to a U.S. parent corporation are 

subject to the I 0 percent tollgate tax. However. the rate is reduced to 7 percent if the 

tax-exempt firm retains a certain percentage of its annual earnings in Puerto Rico for a 

specified period of time. On liquidation. a firm with an old tax-exemption grant may 

distribute all accumulated earnings free of the tollgate tax. 

C. Taxation Under an Old Exemption Grant "Converted" to the 1978 Industrial Incentives 

Act 

The 1978 Industrial Incentives Act did not affect the terms of tax-exemption grants which 

were issued before June 1978. but it allowed 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. 

1. Option One 

During the years remaining until the end of the existing grant. the exempted business paid 

a maximum effective tax rate of 3 to 12 percent of income. with the higher rate applicable to 

a firm that had fewer years left on its original grant. as follows: 

0-4 years 

S-8 years 

9-12 years 

13-16 years 

17-20 years 

More than 20 years 

73.3% 

77.7 

85.5 

90.0 

91.0 

93.3 

Maximum e fective 

tax rate 

12.0% 

10.0 

6.5 

4.5 

4.0 

3.0 

15 The assets which give rise to tax-exempt passive investment income -- generally known as 2(j) assets -- include 

Puerto Rican government bonds. loans for the construction of buildings or acquisition of equipment used by 

a tax-exempt business. mortgages insured by the Puerto Rican Housing Bank and Finance Agency. and certificates 

of deposit in certain banks doing business in Puerto Rico. Banks receiving these tax-exempt deposits are 

required to reinvest the funds within Puerto Rico. although this requirement was not strictly enforced until 

1980. Puerto Rican regulations which were in effect through March 31. 1980. permitted banks to "warehouse" 

936 deposits outside Puerto Rico for up to six months. Puerto Rican rules regarding tax-exempt financial 

investments are explained in Chapter 6. · 
-14-

After the period of original exemption had expired. the firm electing this option was 

automatically entitled to operate partially exempt from taxation for ten more years. During 

the first five years. 50 percent of income was exempt. During the second five years. 

between 35 percent and 50 percent was exempt. depending on the location of the plant. 

2. Option Two 

A company that had six or more years remaining on its tax exemption could have made an 

alternative election. It could exclude 90 percent of its income from taxation and could 

credit two-thirds of the corporate income taxes actually paid against the tollgate tax on 

dividends paid from current earnings. A company that elected this second option· could apply 

for a ten-year extension when the grant expired. but the extension was not automatic. 

As a further inducement to firms to convert to partial tax exemption. the 1978 Act 

provided that. under either conversion option. a firm could credit tollgate taxes paid on 

distributions from pre-1978 earnings against the income taxes due in future years (for up to 

50 percent of such liability in any given year). In addition. dividends paid by converted 

firms out of pre-1978 earnings could benefit from a reduced tollgate tax rate. On 

liquidation. pre-1978 earnings of "converted" firms were exempt from tollgate tax. 

D. Taxation ofCompanieswith an Exemption Grant Under the 1978 Industrial Incentives 

Act 

New grants issued under the 1978 Industrial Incentives Act provided 90-percent exemption 

from income and property tax in the first five years of a firm·s operation. and a 

gradually decreasing rate of exemption during each subsequent five-year period until 

the expiration of the grant. as follows: 

Years of 

exemption 

1-5 

6-10 

11-15 

16-20 

21-25 

Effective tax rate on 

Percentage of income deriv~d ff ~m 

exemption from income manufactunng ~~:--~--,---,~-:-~-

and property tax Minimum I Maximum 

90% 

75 

65 

55 

50 

2.20% 

5.50 

8.75 

9.90 

11.00 

4.50% 

11.25 

15.75 

20.25 

22.50 

16 The minimum and maximum tax rates during a given five-year period are computed on the basis of the statutory 

tax rates. which now vary from 22 percent to 39 percent. Companies which were granted exemptions under prior 

Industrial Incentives Acts are subject to the higher rate of tax (if applicable) in effect when exemptions 

were granted. 
-15-

The duration of a finn ·s grant varied from ten to twenty-five years. depending upon the 

location of its plant. 

The effective tax rates are somewhat lower than those shown because of two additional 

incentives provided by the 1978 Act to encourage labor-intensive operations and assist small 

finns. All grants issued under the Act allow firms an added deduction of 5 percent of production worker payroll from manufacturing income (for up to 50 percent of such income). As 

an alternative to the payroll deduction. a finn with profits of less than $500.000 in any 

year is allowed a IOO-percent tax exemption on the first $100,000 of income. 

If a finn with a partial exemption grant reinvests all or part of its earnings in Puerto 

Rican 2(j) assets (i.e.. assets designated in section 2(j) of the Industrial Incentives 

Act). then the dividends. interest. and rents derived from those assets are I 00-percent 

exempt from Puerto Rican income tax. The intent of the tax exemption for 2(j) earnings is 

to induce 936 corporations to reinvest their business profits in Puerto Rico. However. the 

main incentive to a finn to retain its profits in the Commonwealth arises from the tollgate 

tax provisions of the 1978 Industrial Incentives Act. as follows: 

Dividends paid out of income earned by a tax-exempt business are subject to a 

tollgate tax of 5 percent. instead of l 0 percent. provided that (a) 50 percent of 

such income is invested for five years in 2(j) assets or in the finn ·s own capital 

assets. and (b) not more than I 0 percent of the net income is distributed in each of 

the succeeding five years. The 50 percent of income reinvested during this period 

can be repatriated after the fifth year. 

On liquidation, undistributed earnings are subject to a tollgate tax of 4 percent. 

rather than I 0 percent. provided that 50 percent of such earnings have been investeu 

in the finn ·s own capital assets or in 2(j) assets for a period of at least five 

years. 
Chapter 3 

ECONOMIC DEVELOPMENT IN PUERTO RICO 

The Pue110 Rican and U.S. economies are closely integrated. sharing a common currency and 

common external tariffs. There are no barriers to the free flow of goods, labor, or capital 

between the two countries. During 1983, approximately 75 percent of Puerto Rico's exports 

were to the United States. In recent years, about 90 percent of gross fixed investment in 

Puerto Rico has been derived from U.S. sources. Federal statutes other than domestic tax 

laws are generally enforced in Puerto Rico, some (such as minimum wage legislation) with 

large economic impacts. With a few important exceptions, federal grant-in-aid programs and 

income maintenance programs apply to Puerto Rico. Residents participate fully in the Social 

Security (other than Supplemental Security Income) and Unemployment Insurance programs. 

However. Puerto Rico administers nutritional assistance (such as food stamps) under a block 

grant instead of an entitlement program, and federal payments to Puerto Rican residents for 

Medicaid and Aid to Families with Dependent Children are subject to a cap. 

The ties between Puerto Rico and the United States have helped shape the push for Puerto 

Rican economic development that began in 1948. This chapter briefly surveys Puerto Rican 

economic growth since 1948. and the impact of the combined U.S. and Commonwealth tax exemptions in shaping that growth. 

The recent history of Puerto Rican economic development can be roughly divided into 

several periods. In the period L 948-1972, there was a sustained rise in private investment 

which created a modern manufacturing sector. Employment in manufacturing grew from 55 .000 

in 1950 to 142.000 in 1972. Gross national product and GNP per capita also grew rapidly. 

In the period from 1973 to 1983, however, Pue110 Rican economic progress slowed. Total 

employment and employment in the manufacturing sector were stagnant. Real GNP per capita 

changed little between 1972 and 1983. Private investment in plant and equipment as a 

percentage of GNP fell steadily from 10.3 percent of GNP in 1973 to 4.6 percent in 1983. 

Since 1983 growth has improved. After the recovery from the 1982 recession in 1984 and 

1985. growth from 1985 to 1988 has been significant. Per capita real GNP increased at a 

compound annual rate of 4.5 percent from 1985 to 1988: Private fixed investment has 

recovered to 8.5 percent of GNP. 

I. Growth Since 19481 

Puerto Rico· s economic growth from 194 8 to 1973 has often been referred to as an 

"economic miracle." Table 3-1 shows total and per capita GNP for Puerto Rico during the 

194 7-1988 period. According to this information. Pue110 Rican GNP (expressed in 1972 

1 Throughout the chapter, unless otherwise noted. years are Puerto Rican fiscal years: e.g., 1972 means the twelve 

months ending June 30, 1972. 

-17-
TABLE 3-1 

TOTAL AND PER CAPITA GROSS NATIONAL PRODUCT 

OF PUERTO RICO, 1947-1988 

GNP I GNP per ($ miilion) capitaa 

Fiscal year (constant 1972 dollars) 

1947 

1948 

1949 

1950 

1951 

1952 

1953 

1954 

1955 

1956 

1957 

1958 

1959 

1960 

1961 

1962 

1963 

1964 

1965 

1966 

1967 

1,260.0 

1,307.9 

1,462.0 

1,569.4 

1,652.1 

1,814.4 

1,931.2 

1,972.5 

2,033.4 

2,117.7 

2,182.1 

2,247.5 

2,435.4 

2' 631.1 

2,791.2 

3,007.4 

3,251.8 

3,462.9 

J,749.2 

4, 001. 7 

4,178.2 

Department of the Treasury Office of Tax Analysis 

586 

601 

667 

711 

742 

813 

871 

893 

911 

941 

968 

986 

1,054 

1,124 

1,173 

1,240 

1,316 

1,373 

1,458 

1,534 

1,586 

Fiscal year 

1968 

1969 

1970 

1971 

1972 

1973 

1974 

1975 

1976 

1977 

1978 

1979 

1980 

1981 

1982 

1983 

1984 

1985 

1986 

1987 

1988p 

GNP I GNP per ($ million) capitaa 

(constant 1972 dollars) 

4,385.2 

4,793.6 

5,181.9 

5,488.2 

5,770.9 

6,059.7 

6' 134. 2 

6,026.3 

6,176.7 

6,471.6 

6,817.9 

7,188.7 

7,281.0 

7,369.8 

7' 104. 9 

6,955.1 

7,229.7 

7,452.8 

7,647.1 

8,031.0 

8,425.7 

1,650 

1,780 

1, 911 

1,995 

2,045 

2, 112 

2,129 

2,068 

2,073 

2,125 

2,201 

2,289 

2,287 

2,284 

2, 183 

2, 131 

2,212 

2,275 

2,332 

2,445 

2,558 

SOURCE: Puerto Rico Planning Board, Economic Report to the Governor, (various issues). 

a Based on average of population estimates at the beginning and end of the fiscal year. 

p preliminary 

I 

00 -I 
-19-

clnllnr~) increased at an average annual rnte of 5. 3 percent in the 1950s and 7 .0 perct>nt in 

the 1960s, compared to U.S. average annual growth in this period of 3. 7 percent. Puerto 

Rico's remarkable growth was accompanied by the transformation of the agricultural economy 

of the 1940s to an economy based primarily on services and manufacturing. Manufacturing net 

income surpassed agricultural net income in 1955, while manufacturing employment surpassed 

agricultural employment in 1966. Real GNP per capita rose at an average annual rate of 4. 7 

percent in the 1950s and 5.5 percent in the 1960s, compared to an annual 2.2 percent during 

the 1950-70 period in the United States. (The per capita figures reflect substantial 

emigration from Puerto Rico.) 

Total Puerto Rican employment grew much less quickly than GNP and more slowly than U.S. 

employment. Puerto Rican employment grew by 15 percent between 1950 and 1970, compared to a 

35 percent increase in civilian U.S. employment. Emigration was substantial during the 

petiod. In response to cheaper air fares and better opportunities for employment on the 

mainland. emigration averaged nearly 50,000 persons per year between 1950 and 1960 and 

20.000 per year in the following decade. (See Table 3-2). Since 1970, emigration patterns 

have fluctuated. The average net outflow was approximately 13,000 persons per year in the 

four-year period 1978-81, but increased in 1982-1988 to an average rate of 35,000 per year. 

Table 3-3 shows the change in the sectoral distribution of employment in Puerto Rico from 

I 950 to 1988. The replacement of employment in home needlework and agriculture by 

employment in manufacturing and government was the most fundamental change of the 1950s and 

I 960s. Employment in manufacturing grew at an average annual rate of 3. 9 percent and 5 

percent. respectively, in the late 1950s and I 960s. Government employment grew almost as 

rapidly through the 1950s and 1960s, and employment in construction and other services 

increased strongly in the 1960s. Total non-government employment declined in the 1950s but 

increased in the 1960s and early I 970s. 

A number of factors contributed to the growth of Puerto Rican employment during the 

1960s. Exemptions from local taxes induced U.S. firms to build plants in Puerto Rico. As 

explained in the Fourth Report, Puerto Rican labor was low-cost relative to mainland labor 

and contributed to Puerto Rico's attraction as an investment site. Puerto Rico also had the 

advantage of being inside the U.S. tariff wall, compared to low-wage foreign countries. 

Additionally, it offered a more stable political and economic climate than countries in 

Latin America or the Far East. 

Growth in government employment continued to be strong in the 1970s through 1981, but 

declined in the recession of 1982-83. However, manufacturing employment was virtually 

stagnant in the period 1970-1986 and total non-government employment remained steady or 

declined throughout the decade 1974-1983. The Puerto Rican petrochemical industry suffered 

from the sharp increase in the price of foreign oil in 1973-74. Traditional Puerto Rican 

manufacturing industries, such as apparel, shoes, and textiles, faced increased competition 

from low-wage foreign countries. In the period 1974-75 and again in the early 1980s. the 

entire Puerto Rican economy was adversely affected by the U.S. recession and high U.S. 

interest rates. A reduction in real Federal transfer payments in the latter period 

exacerbated the adverse effect. The Puerto Rican economy experienced a recession in 
-20-

TABLE 3-2 

NET MIGRATION OF RESIDENTS OF PUERTO RICO 

Net migration of residents 

Fiscal year 

1950-1960 

1960-1970 

1970-1977 

1978 

1979 

1980 

1981 

1982 

1983 

1984 

1985 

1986 

1987 

Department of the Treasury 

Off ice of Tax Analysis 

of Puerto Rico 

-493,000 

-201,000 

- 43,640 

- 20,282 

- 6,078 

- 16,101 

- 10,460 

- 33,297 

- 44,433 

- 34,484 

- 28,609 

- 46,619 

- 22,325 

Annual rate 

per mid-period 

population 

-2.19% 

- .79 

- .22 

- .65 

- .19 

- .51 

- . 32 

-1.02 

-1.36 

-1.06 

- .87 

-1.42 

- .68 

SOURCE: Puerto Rico Planning Board, Economic Report to the Governor 

(various issues); U.S. Bureau of the Census, Current 

Population Reports, Series P-25, Nos. 80, 336, and Puerto 

Rico Department of Labor and Human Resources. 
TABLE 3-3 

PUERTO RICAN UNEMPLOYMENT RATE AND DISTRIBUTION OF EMPLOYMENT IN SELECTED YEARS, 1950 - 1988 

(thousands of workers) 

Total Total non- Home Wholesale Finance, Transporta- Fiscal Unemployment employa Gover~ government Agricul- Manufac- needle- Construe- and retail insurance, tion and 

Year rate ment ment e loyment tu re turing work ti on trade real estate utilities 

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

1955 14.3 539 50 489 164 66 29 34 89 n.a. n.a. 1960 13.1 543 62 481 124 81 10 45 97 6 39 

1965 11. 7 617 82 535 107 106 6 56 109 n.a. n.a. 1970 10.7 686 106 580 68 132 * 76 128 13 45 

1971 11.2 699 111 588 61 132 * 81 134 15 47 

1972 11.9 738 131 607 58 142 * 80 135 16 49 

1973 11. 7 745 141 604 49 139 * 78 144 18 49 

1974 12.2 744 140 604 52 141 * 77 141 17 51 

1975 15.3 699 143 556 47 130 * 65 134 17 49 

1976 19.4 678 149 529 44 126 * 50 132 17 44 

1977 20.0 691 157 534 40 135 * 40 136 18 46 

1978 18.7 722 167 555 36 145 * 41 139 19 46 

1979 17.5 735 173 562 36 146 * 44 141 19 46 

1980 17.0 753 184 569 38 143 * 44 138 21 47 

1981 17.9 759 185 574 37 141 * 44 142 23 49 

1982 21. 7 719 171 548 34 134 * 36 141 21 48 

1983 23.4 703 170 533 36 131 * 30 136 22 45 

1984 22.0 743 177 562 40 142 * 34 145 22 41 

1985 21.4 758 180 578 38 138 * 36 147 23 43 

1986 20.5 777 180 597 40 140 * 36 149 26 49 

1987 17.7 834 197 637 35 152 * 41 159 30 52 

1988p 15.9 873 201 672 31 157 * 48 173 30 50 

Average annual growth rate 

1950-1960 -0.9% 3.3% -1.3% -5.3% 3.9% -15.0% 5.2% 0.8% 7.2% 3.4% 

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

1970-1980 0.9 5.7 -0.2 -5.2 0.8 -5.3 0.8 4.9 0.4 

1980-1986 0.4 -0.3 0.7 0.7 -0.3 -2.8 1.1 3.1 0.6 

1985-1986 2.5 0.0 3.3 5.3 1.4 o.o 1.4 13.0 14.0 

1986-1987 2.3 9.4 6.7 -12.5 8.6 13.9 4.7 15.4 6.1 

1987-1988p 4.7 2.0 5.8 -11.4 3.3 17.1 8.8 0.0 -3.8 

Department of the Treasury 

Off ice of Tax Analysis 

Other 

services 

77 

69 

75 

103 

116 

117 

126 

125 

123 

114 

114 

119 

128 

130 

135 

137 

132 

132 

140 

151 

157 

167 

182 

-0.3% 

4.5 

1.5 

2.2 

4.0 

6.4 

9.0 

SOURCES: Puerto Rico Planning Board, Economic Report to the Governor (various issues); Puerto Rico Development Administration, Economic Analysis of the 

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

Study, Draft Report for the U.S. Department of Commerce, April 1978. 

NOTE: Figures for 1971 through 1981 were revised in the Economic Report to the Governor, 1982-1983. 

a Figures may not add to total dUe to rounding errors. 

b Includes only public administration. 

* Less than 2,000 

n.a. not available 

p Preliminary figures 

I 

N 

~ 

I 
-22-

1974-76. then grew hy an average annual rate of 4.2 percent hetween 1976 and 1OR1. Real GNP 

fell 3. 6 percent in the year ending June 1982 and 2. I percent in the year ending June 1983. 

The economy turned around in 1984. with both government and non-government employment 

increasing. Except for transportation and utilities. all sectors of the economy enjoyed 

increases in employment rates in that year. Real GNP grew by 4. 8 percent for fiscal year 

1984. and real per capita GNP grew by 4. 7 percent. Employment in utilities and 

transpo11ation boomed in 1985 and 1986. while government employment stayed about the same. 

Real GNP grew by 3.1 percent in 1985 and 2.6 percent in 1986; real per capita GNP grew by 

2.8 percent in 1985 and 2.3 percent in 1986. Growth accelerated in 1987 and 1988 with real 

GNP growing at an annual rate of 5.0 percent. Manufacturing employment grew by 6.0 percent 

per year from 1986 to 1988, suggesting strong growth in the 936 sector. 

The unemployment rate, shown in column l of Table 3-3, has generally been very high by 

U.S. standards. Unemployment declined through the 1960s to just under 11 percent but rose 

steadily in the period 1970-77. when it peaked at 20 percent. With U.S. recession. and the 

elimination in U.S. fiscal year 1981 of 21 , 173 Puerto Rican public service jobs financed 

through the Federal Comprehensive Employment and Training Program (CET A). the unemployment 

rate increased again, from 17. 0 percent in 1980 to 23 .4 percent in 1983. The unemployment 

rate might have been even higher had it not been for a decline in the adult labor force. 

Labor force participation as a percentage of adult population felJ from 44.5 percent in the 

early 1970s to 41.0 percent in 1983. The unemployment rate reached an all-time annual high 

of 23 .4 percent in the year ending June 1983. The decline in the unemployment rate has 

paralleled the growth in real GNP since I 983. For FY 1988, the unemployment rate averaged 

15.9 percent. 

High levels of unemployment and low labor force participation rates explain most of the 

pove11y in Pue110 Rico. It is estimated that one-half of Puerto Rican families lived below 

the federal poverty level in 1983. 

Federal payments to Puerto Rico are an impo11ant component of personal income. As shown 

in Table 3-4, federal payments include grants to the Puerto Rican government, federal taxes 

earmarked for Puerto Rico, and net transfer payments to individuals, less Social Security 

taxes and other contributions by Puerto Rico. Net federal payments in current dollars were 

$286 million . in 1968 and $4, 135 million in 1986. As a percentage of income from productive 

activity (Puerto Rican GNP). net federal ·payments rose from 7. 7 percent in 1968 to 26.2 

percent in 1986. Both the current-dollar and real amounts of net federal payments continued 

to increase between 1981 and 1986. 

II. Investment in Puerto Rico 

A. ·overall Investment 

A ptimary goal of any economic development program is to increase real income per capita. 

As indicated in the preceding section, ruerto Rico· s development program made substantial 

headway in the period 1947-1973, and real GNP per capita rose from $586 to $2,112 (in 
-23-

TABLE 3-4 

NET FEDERAL PAYMENTS TO PUERTO RICO 

SELECTED FISCAL YEARS 1968-1986• 

($ million) 

I 1968 I 1981 I 1982 I 1983 I 1984 I 1985 I 1986 

Federal grants to Puerto Rican CoDDDOnwealth 

and municipal governments, total 129 1,893 1, 779 1,722 1,768 2,348 2,296 

Food and nutrition assistanceb 5 993 1,016 946 990 935 946 

Education programs 97 92 74 71 82 163 

Public assistancec 31 103 118 124 122 .· 141 156 

Community development block grants 15 115 94 95 122 127 92 

Low-rent public housing 11 96 86 118 111 123 141 

Employment and training programs 8 220 90 82 80 105 113 

All other grants 59 269 283 283 272 835 685 

Federal taxes transferred to CoDDDOnwealth 

government, total 93 290 298 280 318 327 333 

Alcoholic beverage and tobacco 

excise taxes 66 235 245 245 255 260 264 

Customs duties 27 55 53 35 63 67 69 

Net federal transfer payments to 

individuals, totald 64 846 1,144 1,220 1,278 1,364 1,506 

Old age, survivors, and 

disability insurance 1 502 648 714 734 733 801 

Veterans' benefits 59 231 274 289 303 325 336 

All other payments 4 113 222 217 241 306 369 

T<YrAL 286 3,029 3,221 3,322 3,364 4,039 4,135 

Department of the Treasury 

Off ice of Tax Analysis 

SOURCES: U.S. Department of Commerce. Bureau of the Census, Federal Expenditures by State, (various 

years); U.S. Department of the Treasury. Federal Aid to States. FY 1981, FY 1982; U.S. Department 

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

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

• 

b 

c 

d 

In 1968, both the federal and Puerto Rican fiscal years ended on June 30, so all data for FY 1968 is based 

on the same time period. In 1976, however, the federal fiscal year was changed to October I-September 30. 

while the Puerto Rican fiscal year remained unchanged. With thr exception of certain federal transfer 

payments to individuals, data for l 981-1986 are based on the federal fiscal year. 

Effective July 1. 1982, the food stamp program in Puerto Rico was terminated and replaced by a nutritional 

assistance grant program. To make the yearly figures comparable, all food stamp payments to individuals prior 

to July 1, 1982 , are included in the category of block grants for food and nutrition assistance. 

Includes Medicaid, child support enforcement, maintenance assistance (AFDC). and low-income home energy 

assistance. 

All transfer payments (such as employer. employee and self-employment contributions for Social Security) are 

net of associated payments by or on behalf of current or future recipients. 
-24-

constant dollars). Part of the increase was spurred hy increasing inYe~tment. Phy~kal 

investment can lead to an increase in income in two ways: by providing the capital to 

create new, more productive jobs, and by increasing the productivity of those currently 2 employed. 

Components of fixed investment in Puerto Rico are illustrated in Table 3-5 for the years 

1960-1988. Private refinery construction is excluded from the total, because the boom in 

this industry between 1970 and 1972 was based on the large allocation to Puerto Rico of U.S. 

quotas for imported oil (which before 1973 was cheaper than domestic oil) rather than on low 

wages, locational advantages, or other market considerations. The increase in OPEC oil 

prices in 1973 and the consequent termination of the federal quota system eliminated Puerto 

Rico's advantage. In March 1979, the Commonwealth Oil Refining Company (CORCO), the 

ptincipal oil refiner and the largest private corporation in Puerto Rico, filed for 

protection under federal bankruptcy laws. Private refinery construction accounted for 

almost one-third of total private investment in plant and equipment between 1970 and 1972, 

but represented less than 4 percent of the total in 1973 and most later years. 

Total and private investment (expressed in 1972 dollars) grew rapidly in the period 

1960-73. but dropped off during the 1974-76 recession and continued to drop until 1983. For 

example. annual private investment in machinery and equipment, which exceeded $400 million 

(in 1972 dollars) in the early 1970s, dropped to about $300 million during the J 974-76 

recession and continued to decline in every year between 1978 and 1982. Similarly, housing 

construction, which rose almost continuously until 1972 to a peak of $472 million, declined 

sharply in nearly every year until 1984. Machinery and equipment investment rose slightly 

in 1983 to a level equal to 60 percent of the average in the early 1970s. It also recovered 

modestly in 1984 but still remained far below the levels of the early 1970s. Investment in 

machinery and equipment then increased strongly from 1984 to 1988. In 1986-1988 it was 

substantially above the levels reached in the early J 970s. 

Puerto Rican government investment has also expanded since 1960. Total government 

investment by public enterprises rose from about $300 million in t 969 to almost $600 million 

iri 1975, then fell sharply to under $300 million in 1984. Commonwealth investment was 

financed largely by external borrowing, from the United States and elsewhere. In response 

to rising interest costs, the Commonwealth cut back sharply on borrowing after 1975. and the 

rate of new investment by government and public enterprises has generally been less than 

$0.4 billion annually since 1976. 

Aggregate physical investment in Puerto Rico (except private refinery construction) rose 

nearly every year between J 960 and 1973. The annual rate of investment declined by nearly 

30 percent between 1973 and 1978, from $1.5 billion to.$1.1 billion. From 1978 to 1983. 

annual · investment fell by another 35 percent, from $1. I billion to $0. 7 billion. However. 

real investment has recovered strongly since 1983. Total fixed investment almost doubled 

2 A second major contributor to economic growth is investment in h umar:i capital --the formal education and on-the-job 

training of the labor force. 
-25-

TABLE 3-5 

COMPONENTS OP REAL PIXED INVESTMENT IN PUERTO RICO 

FISCAL YEARS 1960-1988 

(millions of 1972 dollars) 

ota investment 

excluding 

private Government 

refinery Machinery and public 

construe- and enterprise 

Year ti on Total e ui ment Housin investment 

1960 539 71 67 145 145 182 

1961 538 89 82 123 161 172 

1962 634 129 122 158 190 164 

1963 683 121 117 195 195 176 

1964 776 115 89 235 227 225 

1965 879 173 94 249 292 244 

1966 978 155 119 265 351 243 

1967 1,051 222 117 290 380 264 

1968 1, 111 221 134 263 407 307 

1969 1,205 197 108 341 423 332 

1970 1,296 391 118 413 396 369 

1971 1,413 422 134 433 441 405 

1972 1,565 332 136 426 472 531 

1973 1,500 194 170 432 437 462 

1974 1,419 203 181 357 398 483 

1975 1,438 186 117 312 336 673 

1976 1, 272 152 125 360 295 493 

1977 1,059 93 81 354 249 387 

1978 1,090 81 71 379 291 348 

1979 1,087 77 67 375 250 395 

1980 1,072 85 64 361 228 419 

1981 998 97 84 331 192 391 

1982 781 82 72 228 165 316 

1983 712 68 59 262 149 242 

1984 825 115 108 291 134 292 

1985 945 102 96 380 151 320 

1986 973 104 96 453 146 278 

1987 1,184 141 133 487 181 383 

1988p 1,427 172 166 544 215 502 

Department of the Treasury 

Office of Tax Analysis 

SOURCES: Puerto Rico Planning Board, Economic Re£ort to the Governor, Tables 2, 12, 

and 20 (various issues); unpublishe estimates of private refinery 

construction by the Puerto Rico Planning Board. 

a Puerto Rico's large allocation of U.S. oil import quotas for foreign oil led to a 

boom in refinery construction between 1970 and 1972. 

p Preliminary figures 
-26-

from 1 QR1 to 1988 anc1 is almost hack to the peak levels of the early 1 Q70s. From 1 o~n to 

1988 total fixed annual investment in Puerto Rico was on the average about 16 percent of 

annual GNP, compared to 25 percent in the period 1966-73. In 1988 it was about 20 percent 

of GNP. 

Several factors were responsible for the 1972 to 1983 decline in investment in Puerto 

Rico. As explained in detail in the Fom1h Repo11, 3 

wage rates in manufacturing indust1ies 

rose much faster in Puerto Rico than on the mainland between 1955 and 1971, and rose 

slightly faster than U.S. wages between 1971 and 1982. The rise in wage rates reduced 

Puerto Rico ·s ability to attract investment in labor-intensive industries. such as apparel. 

leather products, and tobacco products. 

· Changes in U.S. tax Jaw since 1962 and before the 1986 Tax Reform Act (such as the 

investment tax credit and the reduction in the maximum statutory corporate income tax rate 

from 52 to 46 percent) reduced the effective tax rate on income from physical capital and 

thereby reduced Puerto Rico ·s tax advantage relative to the United States. The accelerated 

cost recovery system enacted in 1981 fu11her reduced the effective tax rate on income from 

capital. as shown below: 

Effective U.S. Tax Rates on New Depreciable 

Assets, Selected Industries 4 

1979-1981 1981-82 

Indust Law Law 

Food and kindred products 43.5 20.4 

Apparel 40.6 23. l 

Chemicals 28.6 8.5 

Fabricated metal products 47.3 24.7 

Machinery and instruments 38.2 18.6 

Electrical and electronic 

equipment 31.9 15.8 

Post-1982, 

Pre-1986 Law 

26.7 

28.9 

l 7. 7 

32.2 

25.7 

25.7 

By reducing the basis of depreciable property by a portion of the investment tax credit and 

by tightening certain leasing provisions, TEFRA offset roughly one-third of the 198 l tax cut 

on income from physical capital. 

The changes in Puerto Rican wage r~tes and U.S. tax law reduced Puerto Rico· s locational 

advantages relative to the United States as a site for plant and equipment. Changes in the 

U.S. tariff structure in the 1960s reduced the locational advantage of Pue110 Rico relative 

3 

4 

See pages 43-47. 

These effective tax rates are derived from the Treasury Department depreciation tax model. They are based on 

investment patterns by corporation.sin the United States, using the actual asset mix in each industry and assuming 

a 4 percent real after-tax rate of return and 6 percent inflation. 
-27-

to foreign countries. as the price advantage \Vhich Puerto Rican prndnc-t~ conld en.ioy in the 

U.S. market relative to foreign products was cut. After the Kennedy round of tariff negotiations in the 1960s. the United States cut its tariff rates by 40 to . 50 percent on 

average. which exposed Puerto Rican (and U.S.) manufacturers to more vigorous import 

competition. Foreign competitors utilizing low-wage labor penetrated the U.S. market, and 

U.S. investors also started manufactming in low-wage countries and exporting back to the 

United States. U.S. investors who established foreign manufacturing subsidiaries could 

obtain the benefit of 100-percent U.S. tax exemption on current income from physical assets. 

since the United States generally does not tax such income until it is repat1iated to the 

United States. 5 

B. Industry Composition 

Changes in Puerto Rico 's comparative advantages are reflected in the basic change in the 

manufacturing sector since J 970. Puerto Rican business expansion has been concentrated in 

four high-technology industries: chemicals (including pharmaceuticals), scientific instruments. electrical and electronic equipment, and machinery. These U.S. industries are among 

the leaders in investment in research and development (R&D) spending. 6 Until the enactment 

of TEFRA. when a possessions corporation produced (in whole or in part) a product in Puerto 

Rico. the return on the R&D and other intangible property associated with the product 

enjoyed unique tax advantages under U.S. law. As TEFRA's changes have been phased in, some 

of these tax advantages have lessened. 

Table 3-6 presents the industry composition of Puerto Rican manufacturing income. 

Between 1960 and 1970~ the composition of the manufacturing sector changed little, except 

that the food industry declined as a percent of the total, and the chemical industry 

increased sharply as a percent of the total. Between J 970 and 1988, however, the manufacturing sector experienced a basic change by moving from certain labor-intensive industries 

into high-technology industries. The combined income shares of the food, apparel, and 

stone. clay. and glass industries fell from 40 percent to 18 percent. Income earned by the 

chemical industry grew from 11 percent to 44 percent of the total income originating in 

Puerto Rican manufacturing. while the income of the machinery and metal products industries 

(including electrical and electronic equipment) grew from 19 percent to 29 percent. Nearly 

5 

6 

This exemption is also a\'ailable for subsidiaries incorporated in the U.S. possessions. 

In 1980. electrical and electronic equipment was first among sixteen manufacturing industry categories in the 

dollar amount of spending on R&D in the United States, with estimated total spending of $8.9 billion. 

As a percentage of spending on plant and equipment, R&D spending was 103 3 in instruments. 92 3 in electrical 

and electronic equipment, 503 in non-electrical machinery, and 373 in chemicals. Figures are based on 

actual 1980 spending and are from Annual McGraw-Hill Survey of Business' Plans for Research and Development 

Expenditures, 1981-84. 
TABLE 3-6 

NET INCOME ORIGINATING IN PUERTO RICAN MANUFACTURING 

FISCAL YEARS 1960, 1970, 1980, 1983, AND 1988 

All Manufacturing industries 

Food and kindred products 

Tobacco products 

Textile mill products 

Apparel 

Furniture and wood products 

Printing and publishing 

Chemicals 

Stone, clay, and 

glass products 

Machinery and metal 

products 

Other manufacturing 

Department of the Treasury 

·office of Tax Ana"lysis 

1960 

Amount I ~f net 

1ncome 

288.8 

66.7 

10.4 

13.9 

50.7 

8.8 

11.2 

9.8 

18.8 

54.7 

43.7 

Percent 

of 

total 

100.0% 

23.1 

3.6 

4.8 

17.6 

3.0 

3.9 

3.4 

6.5 

18.9 

15.1 

AmoWlt 

of net 

income 

957.6 

161.3 

36.4 

41.1 

172.0 

26.2 

22.6 

109.3 

49.1 

191.5 

148.0 

1970 

I 

($ million) 

Percent 

of 

total 

100.0% 

16.8 

3.8 

4.3 

18.0 

2.7 

2.4 

11.4 

5.1 

19.4 

15.5 

Amount 

of net 

income 

1980 

4,808.7 

548.5 

46.3 

39.6 

360.7 

29.6 

58.8 

1,583.2 

95.4 

1,453.7 

597.0 

Percent 

of 

total 

100.0% 

11.4 

1.0 

0.7 

7.5 

0.6 

1.2 

32.9 

2.0 

30.2 

12.4 

SOURCE: Puerto Rico Planning Board, Economic Report to the Governor, Table 7 (various years). 

a Percentages do not add to 100 due to rounding errors. 

p Preliminary figures 

1983 

AmoWlt 

of net 

income I 

Percent 

of 

total a 

5,734.9 100.0% 

564.8 9.8 

55.2 1.0 

31. 7 0.6 

408.2 7.1 

27.3 0.5 

69.5 1.2 

2,268.9 39.6 

77.3 

1,752.5 

479.4 

1.3 

30.6 

8.4 

1988p 

Amowit I Percent 

~f net of 

income total 

9,432.5 

1,152.0 

84.8 

48.3 

458.7 

36.2 

104.5 

4,180.8 

138.9 

2,744.8 

483.6 

100.0% 

12.2 

0.9 

0.5 

4.9 

0.4 

1.1 

44.3 

1.5 

29.1 

5.1 

I 

N 

00 

I 
-29-

all investments in these industries have been made hy possessions col"(lOmtions. The amount 

of current investment of possessions corporations, by indust'?', and the employment 

associated with these investments, is the subject of the next chapter . 

., As noted in Table 3-3. employment figures for 1971 through 1981 were revised downward in the 1982-83 

Economic Report to the Governor. The data on distribution of employment in Puerto Rican manufacturing 

industries. published by the Puerto Rican Department of Labor in its Census of Manufacturing Industries 

in Puerto Rico and cited in the Fourth Report (Table 3-8. p. 53) have not been revised accordingly. However. 

the pattern presumably remains the same as indicated in the Fourth Report. namely a shift in employment 

away from tobacco, textiles. apparel, leather goods, wood products, and stone, clay and glass products to 

chemicals (including pharmaceuticals). electrical and electronic equipment. scientific instruments. and 

machinery and, to a lesser extent. to the food-processing, paper. and plastics industries. 
Chapter 4 

CHARACTERISTICS OF POSSESSIONS CORPORATIONS 

AND REVENUE EFFECT OF SECTION 936 

This chapter describes the characteristics of possessions corporations by industry. It 

presents data on their assets. income, tax benefits. employment. and payroll in tax year 

1983 .

1 The information is drawn from unaudited tax and employment returns filed by 

possessions corporations for tax year 1983. Returns with accounting periods beginning on or 

after January I, 1983, were subject to new law under TEFRA; returns with accounting periods 

beginning before that date were subject to old law. A total of 625 corporations. of which 

527 were manufacturing companies, claimed possessions tax credits in 1983. The 527 

manufacturing firms claimed estimated possessions tax credits of $1.895 million and derived 

estimated tax benefits of $1,641 milJion. 

To estimate the tax benefit received by possessions corporations. the total possessions 

tax credit claimed is adjusted downward to take account of other tax benefits (e.g .. 

accelerated depreciation, investment tax credits and foreign tax credits) which such 

corporations might have claimed if. instead of operating as possessions corporations. they 

had operated in the United States. Only corporations engaged in manufacturing are assumed 

to derive tax benefits. Activities other than manufacturing generally did not qualify for 

exemption grants in Puerto Rico. Moreover, the evidence suggests that. in the absence of 

the section 936 credit, the foreign tax credit for Puerto Rican taxes paid would have offset 

most of the U.S. tax liability for non-manufacturing activities. Therefore, the tables in 

this chapter focus primarily on manufacturing possessions corporations. 

Employment data are available for only 378 of the manufacturing possessions corporations. 

Therefore, the figures in Tables 4-6 and 4-7 for number of employees and compensation by 

industry had to be estimated. Actual data on wages and number of employees for the 378 

firms were weighted up by industry-specific cost-of-goods-sold and asset data, as explained 

in section Ill of this chapter and in appendix C. Over all manufacturing industries. the 

average compensation per employee was approximately $14,800 and the average tax benefit per 

employee was approximately $ J 8,500. · 

1 

Returns are for accounting periods ending between July 1, 1983 and June 30, 1984. Because most possessions 

corporations file on a calendar year basis. tax year 1983 corresponds closely to calendar tax year 1983. A few 

1 returns used different accounting periods for 1982 and 1983 in order to delay eligibility under TEFRA rules. 

For example. some companies used a January l, 1982 to December 30. 1982. accounting period for 1982 and a 

December 31 , 1982 to December 30, 1983 accounting period for 1983. 
-32-

This chapter also rresents summary data for 1974 through 1983. These data indicate the 

following trends: 

The number of possessions corporations in manufacturing has tended to fluctuate 

between 400 and 500. ranging from a low of 385 (in 1977) to a high of 527 (in 1983). 

Possessions corporations' tax benefits rose from about $400 million in 1974 to 

about $1. 8 billion in 1982 and then decreased to $1. 6 billion in 1983. The increase 

from 1974 to 1983 amounts to an increase of over I 00 percent in inflation-corrected 

dollars. ·· 

Between 1974 and 1982, the tax benefits rose from 92 percent to 148 percent of total 

compensation of employees of possessions corporations. Following the passage of 

TEFRA, however. tax benefits as a percentage of compensation fell to 12.5 percent in 

1983. (Some 1983 returns still fell under the pre-TEFRA rules because their fiscal 

years began before 1983. A comparison of tax benefits in 1982 and 1983 received by 

companies required to use the TEFRA provisions is presented in Chapter S.) 

The final section of this chapter explains the method used in estimating the tax benefits 

of section 936 and discusses the possibility of indirect employment effects arising from 

section 936 provisions. It also examines the extent to which federal tax revenues would 

increase in the absence of section 936. 

I. Assets and Income in Tax Year 1983 

A. Asset Composition of Puerto Rican Investment 

Table 4-1 is based on corporate balance sheets filed as part of U.S. tax returns. Only 

physical and financial assets are directly observable from balance sheets because intangible 

assets are generally carried on a corporation's books at a zero basis. The table shows that 

the total assets of the possessions corporations filing 1983 U.S. tax returns were $22.2 

billion. Seventy-eight percent of the total assets, or $17.3 billion, was held by 

manufacturing companies which benefited from total or partial exemption from Puerto Rican 

taxes. Net plant and equipment of 936 manufacturing firms (shown as "net depreciable 

assets" on Table 4-1) amounted to $1. 9 billion. of which $794 million (42 percent) was owned 

by the pharmaceutical industry. The electrical and electronic equipment and food products 

industries also had substantial amounts of plant and equipment in Puerto Rico. with 16 

percent and 10 percent of the total. respectively. 

Relative to corporations operating in the United States, possessions corporations have a 

disproportionately small share of their assets in real fixed assets. Net plant. equipment. 

and property represented l l percent of the total book assets of manufacturing possessions 
TABLE 4-1 

SELEC!'ED BAI.ARCE SHEET D.IP'ORRATI:<B BY IlllXJS'fta', 1983 

($ thousand) 

Manufacturing industries 

All Manufacturing Food and kindred Textile mill Chemicals 

industries total roducts products pa rel Paper Total Pharmaceuticals All other 

Number of corporations 625 527 25 6 82 9 99 62 37 

Total Assets 22,204,669 17,320,908 1,484,123 68,815 579,215 36,226 7,977,321 7,386,638 590,683 

Cash 3,343,079 3,189,927 629,766 4,993 123,457 2,603 1,044,419 897,233 147,186 

Accounts receivable 3,993,481 3,108,894 300,941 10,921 200,594 6,449 1,174,392 999,710 174,683 

Inventories 1,686,131 1,609,619 164,889 3,406 73,423 3,054 419,430 366,455 52,975 

U.S. Government obligations 616,440 541,055 0 0 5,551 56 189,239 158,383 30,856 

Other current assets 1,254,684 1,216,979 13 ,905 694 8,872 717 711,085 688,798 22,287 

Mortgage and real estate loans 1,654,979 72,173 12,226 0 2,423 0 0 0 0 

Other investments 5,676,554 4,740,488 88,883 1,164 126,882 21,332 2,990,685 2,916,541 74,145 

Depreciable assets 4,117 ,925 2,894,746 265,191 3,963 57,728 3,334 1,237,633 1,123,482 114,152" 

Less: Accumulated depreciation 1,388,479 1,015,546 84,265 2,824 30,688 1,564 373,181 329,237 43,944 

Net depreciable assets 2,729,447 1,879,200 180,926 1,139 27,040 1, 771 864,452 794,245 70,208 I 

w 

Other assets 1,249,878 962,575 92,587 46,497 10,971 244 583,618 565,273 18,345 w 

I 

Total Liabilities and Stockholders' Equity 

Accounts payable 1,680,183 927,423 244,674 381 49,680 821 228,070 185,528 42,542 

Notes payable in less than one year 657,779 320,965 28,490 7 2,840 626 179,881 170,374 9,507 

Other current liabilities 2,403,976 364,012 40,698 306 19,430 1,609 157,393 133,574 23,819 

Notes payable in one year or more 571, 139 222,536 7,237 47 13,095 136 121,590 103,725 17,865 

Other liabilities 764,564 336,766 18,405 616 1,529 0 128,040 119,830 8,210 

Capital stock 1,992,953 1,185,250 230,146 371 25,739 1,198 419,574 342,824 76,750 

.Retained earnings, total 14,134,075 13,963,956 914,472 67,085 466,902 31,837 6,742,772 6,330,782 411,989 

Appropriated 238,429 191,878 13,149 0 0 1,689 2,857 2,266 591 

Unappropriated 13,895,647 13,772,078 901,323 67,085 466,902 30,148 6,739,915 6,328,517 411,398 
TABLE 4-1 - continued 

Manufacturing industries - continued 

Rubber and Leather and Machinery, Electrical and Instruments 

plastic leather Stone, clay, and Fabricated except electronic and related All other 

products products glass products metal products electrical equipment products manufacturing 

Number of corporations 13 17 9 29 12 134 42 50 

Total Assets 110,457 191,026 55,235 310,337 169,425 3,668,945 1,047,066 1,622,717 

Cash 7,337 24,069 6,401 44,392 23,296 980,290 197,223 101,681 

Accounts receivable 24,854 66,247 30,062 62,731 53,146 623,227 151,413 403,916 

Inventories 11,590 34,762 2,637 35,948 26,203 477,633 84,012 272,630 

U.S. Government obligations 0 2,955 0 7,414 3,030 91,975 223,521 17,313 

Other current assets 1,406 419 175 4,003 824 338,807 44,476 91,594 

Mortgage and real estate loans 0 327 0 0 0 48, 727 8,051 417 

Other investments 31,282 46,058 11,247 60,698 37,289 742,375 179,922 402,670 

Depreciable assets 44,665 20,307 8,559 95,461 19,749 495,298 178,963 463,895 

Less: Accumulated depreciation 13,189 7,223 6,504 31,863 5,875 202,084 48,582 207,704 

Net depreciable assets 31,476 13,084 2,054 63,599 13,874 293,214 130,381 256,191 

Other assets 2,512 3,104 2,658 31,552 11, 763 72,697 28,068 76,305 I 

w 

~ 

Total Liabilities and Stockholders' Equity I 

Accounts payable 2,630 17,670 652 20,625 21,457 185,957 48,749 106,058 

Notes payable less than 1 year 1,585 2,281 595 6,451 2,920 31,256 26,850 37,182 

Other current liabilities 6,501 5,549 728 3,950 3,891 83,786 18,314 21,858 

Notes payable 1 year or more 2,219 3,243 2,500 8,020 172 51,250 5,107 7,919 

Other liabilities 484 423 1,115 1,911 1,115 146,856 5,292 30,977 

Capital stock 14,724 -4,030 470 30,801 5,927 183,386 68,419 208,526 

Retained earnings, total 82,314 165,890 49,175 238,579 133,943 2,986,455 874,336 1,210,197 

Appropriated 9, 715 0 3,646 0 0 101,324 51,599 7,899 

Unappropriated 72,599 165,890 45,529 238,579 133,943 2,885,130 822,736 1,202,298 
TABLE 4-1 - continued 

Nonmanufacturing industries 

Other 

Normanu- Transportation, Finance, services and 

facturing communications, insurance, industries not 

total Construction and utilitie ~ Wholesale trade Retail trade real estate reported 

Number of corporations 98 8 5 25 7 23 30 

Total Assets 4,883,763 36,573 946,914 63,570 124,899 3,620,076 91,730 

Cash 153,152 934 30,751 1,635 10,174 104,647 5,009 

Accounts receivable 884,586 9,469 62,114 17,408 11, 120 735,629 48,847 

Inventories 76,512 130 22,565 10,760 23,833 17,756 1,468 

U.S. Government obligations 75,385 0 0 0 0 75,385 0 

Other current assets 37,705 2,538 3,982 1,959 18,526 9,184 1,515 

Mortgage and real estate loans 1,582,806 38 0 0 0 1,582,687 81 

Other investments 936~067 1,053 18,145 7,408 18,292 879,220 11,949 

'Depreciable assets 1,223,179 5,925 1,084,292 14, 710 57,537 33,296 27,420 

Less: Accumulated depreciation 372,933 2,446 327,945 3,798 24,581 1,804 12,359 ' Net depreciable assets 850,246 3,480 756,347 10,912 32,956 31,492 15,061 w 

(J\ 

Other assets 287,304 18,931 53,009 13, 489 9,997 184,076 7,801 ' 

Total Liabilities and Stockholder Equity 

Accounts payable 752,761 4,380 38,084 7,638 41,055 654,249 7,354 

Notes payable in less than one year 336,814 156,677 15,183 3,917 3,290 294,158 4,589 

Other current liabilities 2,039,964 4,104 39,244 3,598 1,121 1,989,935 1,962 

Notes in payable one year or more 348,603 4,092 100,002 7, 726 28,846 205,131 2,806 

Other liabilities . 427, 798 161 4,771 39 1,214 418,941 2,672 

Capital stock 807,703 294 730,129 14,757 14,199 28,837 19,487 

Retained earnings, total 170,120 7,865 19,501 25,895 35,174 28,824 52,861 

Appropriated 46,551 0 14,020 43 0 32,488 0 

Unappropriated 123,569 7,865 5,481 25,852 35,174 -3,664 52,861 

Department of the Treasury 

Off ice of Tax Analysis 
firms. compared to 30 percent for the same ind11C\tries in the l •nited States. 2 This reflects. 

at least in pa11, the tax benefits from holding financial assets in Puerto Rico. Table 4-2 

shows that the relatively small share of fixed real assets in total book assets of 

possessions companies was borne out in all industries for which data are available. The 

value of possessions corporations' fixed real assets is also small in relation to their 

income. In 1983. manufacturing possessions corporations' net property, plant and equipment 

for companies not electing the profit-split method was 46 percent of before-tax net income 

per return. compared to almost 500 percent for U.S. manufacturing corporations. 

Table 4-3 compares. for non-profit-split possessions corporations and mainland firms, 

ratios of operating profits to operating assets in selected manufacturing industries. The 

assets of these non-profit-split corporations account for 80 percent of all of the assets of 

possessions corporations in Puerto Rico. Operating income, which includes the return to 

intangibles. is expressed as a percentage of operating assets, which include property, plant 

and equipment. inventories, and net receivables. In 1983, the before-tax return on 

operating assets for non-profit-split manufacturing possessions corporations (54. 1 percent) 

was more than 5 times the ratio for mainland manufacturing operations (10.3 percent). 

The possessions corporations ratios may be slightly misstated. The operating assets of 

possessions corporations do not include the value of land and buildings leased from the 

Puerto Rican government. Possessions corporations are less likely than mainland corporations to have initial losses. There are also cost differentials between Puerto Rico and the 

mainland. For some inputs Puerto Rican costs are lower, while for others the reverse is 

true. Lower wages in Puerto Rican manufacturing, for example, may be offset bl higher costs 

for utilities and transportation. However, as indicated in the Fourth Report, such factors 

can explain only part of the large discrepancy in profitability of manufacturing in Puerto 

Rico and the United States. Income from intangible assets assigned to possessions 

corporations is an important factor in explaining the balance. It is notable, for example, 

that the range of profit ratios for the mainland firms is only 10 points (9 to 19 percent), 

while for possessions corporations the range is much wider (27 to 77 percent), with the 

highest profit ratios in the high-technology sectors. 

2 

3 

The Commonwealth government owns land and buildings that it leases to private- investors (936 firms. for~ign firms. 

and Puerto-Rican-chartered firms). Not all of the property, valued at $297 million in June 1983, is under lease at 

any given time. If three-fourths of the government-owned plant and property were under lease to possessions 

corporations in I 982 and if this property were included in fixed assets, the ratio of 936 fixed assets to total 

assets would increase from 11 to t 4 percent. 

See pages 61-65. 
----~- --

TABLE 4-2 

NET PLANT, EQUIPMENT AND PROPERTY AS A PERCENTAGE 

OF TOTAL ASSETS FOR POSSESSIONS CORPORATIONS AND 

CORPORATIONS OPERATING IN THE U.S., 1983 

936 Assets by 

industry as a 

percent of all 

Industry 936 assets• 

All manufacturing industries 100.0% 

Food and kindred products 8.6 

Textile mill products * Apparel 3.3 

Paper and allied products * Pharmaceuticals 42.6 

All other chemicals 3.4 

Rubber and plastic products 0.6 

Leather products 1.1 

Stone, clay, and glass products * Fabricated metal products 1.8 

Machin~ry, except electrical 1.0 

Electrical and electronic 21.2 

equipment 

Instruments and related products 6.0 

Department of the Treasury 

Off ice of Tax Analysis 

Net plant, equipment, and property 

as a percentage of total assets 

by industry 

Corporations 

936 operating in 

corporations the U.S. 

11% 30%b 

12 36 

2 32 

5 n.a. 

5 57 

11 29 

12 44 

28 35 

7 n.a. 

4 46 

20 31 

9 30 

8 26 

12 30 

Column 

Column 

37% 

33 

6 

n.a. 

9 

38 

27 

80 

n.a. 

9 

65 

30 

31 

40 

2 

3 

SOURCES: Tax Form 1120 filed by possessions corporations; Federal Trade Commission, Quarterly Financial Report. Fourth 

Quarter 1984. 

* Less than 0.53. 

a The percentages by industry sum to 90 percent, rather than l 00 percent. because data for industries with fewer than three firms are not 

shown separately. All manufacturing firms are, however, included in the aggregate data shown in row l. 

b The average for all corporations is a weighted average with industry weights based on the industrial mix of possessions corporations. The 

unweighted average for all corporations operating in the U.S. is 393. 

n.a. not available 

I 

w 

-....) 

I 
-38-

TABLE 4-3 

BEFORE-TAX OPERATING INCOME AS A PERCENT OF OPERATING ASSETS 

FOR POSSESSIONS CORPORATIONS NOT ELECTING PROFIT-SP~T METHOD• 

AND CORPORATIONS OPERATING IN THE U.S., 1983 

Before-tax 

as a ercent 

Mainlan 

Industry o erations cor orations 

All manufacturing 10.3% 54.1% 

Food and kindred products 13.7 40.2 

Chemicals and related products 10.1 72.1 

Pharmaceuticals 18.7 77 .5 

Fabricated metal products 10.6 27.8 

Machinery, except electrical 9.1 42.6 

Electrical and electronic equipment 8.5 67.3 

Instruments and related products 12.1 69.5 

Department of the Treasury 

Office of Tax Analysis 

SOURCE: Tax return Form 1120 filed by possessions corporations; 

Federal Trade Commission, Quarterly Financial Report, First 

Quarter, 1984. 

a 

b 

Because firms electing the profit-split method did not report most 

of the income s ta temen t information, they are excluded from this 

table. 

Operating income is defined as gross sales less cost of goods sold 

and less all other deductions except taxes, interest and charitable 

contributions. Operating assets include net property, plant, ~nd 

equipment, inventories, and net accounts receivable. 
-39-

At year-end 198::L all possessions corporations held over $10 billion in financial assets: 

cash, net accounts receivables, certificates of deposit (CDs), and other financial investments.4 The cash assets category, which may include short-term CDs, was $2. l billion. The 

amount of total financial assets in 1983 -- over $I 0 billion -- was more than six times the 

value of 936 manufacturing corporations' physical plant and equipment net of depreciation. 

As explained in chapter 6, the tax exemption for Qualified Possession Source Investment 

Income (QPSII) makes Puerto Rico a very advantageous location for financial investments 

compared to both the United States and foreign countries. The only limit on the amount of 

qualified financial investments which can be made by a possessions corporation out of its 

retained earnings is that no more than 45 percent of its gross income can come from such 

investments for the three-year period immediately preceding the close of its taxable year. 

(This limit was reduced under the Tax Equity and Fiscal Responsibility Act to 45 percent for 

tax years beginning in J 983 , 40 percent for tax years beginning in i 984. and 35 percent for 

tax years beginning in 1985 and 1986. It has been further reduced under the Tax Reform Act 

of 1986 to 25 percent for tax years beginning in 1987 and thereafter.) 

B. Retained Earnings 

Table 4-1 also shows evidence of the 936 manufacturing companies· incentive to retain 

earnings. In 1983, these companies reported $ 14.0 billion of retained earnings. Fo11y-five 

percent of retained earnings ($6.3 billion) was held by possessions corporations in the 

pharmaceuticals industry. Twenty-one percent ($3. 0 billion) was held by the electrical and 

electronics industry. Retained earnings represented 81 percent of total liabilities and 

stockholders· equity of manufacturing possessions corporations. The comparable figure for 

manufacturing corporations operating in the United States in the same industries (using the 

936 industry mix) was 35.5 percent. The high level of 936 retained earnings is probably a 

response to limited alternatives under the Internal Revenue Code for making low-tax 

financial investments, as well as a response to Puerto Rico's tollgate tax on profits. As 

explained in Chapter 2, the rate of tollgate tax is reduced from 10 percent to 4 or 5 

percent if a company operating in Puerto Rico retains a specified percentage of its profits. 

and, of course, is not paid at all on funds as long as they are retained. 

C. Total Receipts 

Table 4-4 shows that total receipts of the manufacturing possessions corporations not 

electing the profit-split method5 

were $10.9 billion, of which $10.3 billion were 

attributable ,to business receipts. Most of the remainder was attributable to interest on 

4 See Table 6-1 for the composition of these financial investments. 

5 Because firms electing the profit-split method did not generally report income statement information. they were not 

included in the table . 
-40-

nongovernment secu1ities. such as CDs in Puerto Rican hanks. Interest on Puerto Rican. 

State, and local government securities is excluded from gross income for federal tax 

purposes and therefore is not included in the total receipts shown in Table 4-4. 

The electrical and electronic industry accounted for 24 percent of the business receipts 

of malnufactwing possessions companies not electing the profit-split method. Pharmaceuticals followed close behind. with 22 percent of business receipts. In 1982, pharmaceuticals 

accounted for 34 percent; the drop in pharmaceuticals' share is partly due to their greater 

adoption of the profit-split method. Companies electing the profit-split method are not 

represented in the table. 

D. Net Taxable Income per Tax Return 

Net taxable income repo11ed on the U.S. corporation income tax return amounted to $3.3 

billion for manufacturing possessions corporations not electing the profit-split method. 

(For all corporations including those electing the profit-split method, the figure is $4.1 

billion. See Table 4-5.) This amounts to 220 percent of the net depreciable assets of 

those corporations. The industry with the greatest amount of net income for non-profitsplit firms was pha1maceuticals with $1.3 billion of net income, which represents 39 percent 

of the total net income of non-profit-split manufactming possessions corporations. The 

figures for a11 pha1maceutical fitms, including profit-split firms, are $1. 9 billion and 46 

percent. Both profit-split and non-profit-split pharmaceutical firms had income equal to 

about 240 percent of net depreciable assets. The electtical and electronic equipment 

industry had net income of $1008 million, accounting for 24 percent of the combined net 

income for manufacturing fitms. Electtical and electronic equipment fitms not electing the 

profit-split method had net income of $916 million, which represented 28 percent of income 

for all non-profit-split manufacturing firms. Net income for the electrical and electronic 

equipment fitms, both profit-split and non-profit-split, represented 340 percent of their 

net depreciable assets. 

E. Distributions 

The final line in Table 4-4 shows that non-profit-split manufacturing possessions 

corporations repo11ed $2.262 million of distributions, which was 68 percent of their net 

income in tax year 1983. This represents an increase over the 1982 level of distributions 

( 60 percent of net income) and a large increase over the 1981 level ( 41 percent of net 

income). Fifty-four percent of distributions by non-profit-split manufacturing corporations 

in 1983 was atttibutable to the electiical and electronic equipment industry. In 1982, the 

dominant industry for distributing profits was phaimaceuticals. which accounted for 59 

percent of all disttibutions. Again. this drop is pat1ly attributable to the greater 

adoption of the profit-split method by the pha1maceutical industry. 
TABLE 4-4 

SELECTED INCOME STATEMENT INFORMATION BY INDUSTRY 

FOR COMPANIES NOT ELECTING PROFIT METHOD, 1983 

($ thousand) 

Manufacturing industries 

Food and I I Apparel I All Manufactur-1 kindred Textile I Chemicals 

industries ing tot al products mill products Paper I Total I Pharmaceuticals I All other 

Number of corporations a 557 463 21 6 82 8 66 39 27 

Total receipts 12,329,146 10,944,350 962,897 36,440 588,742 31,151 2,733,513 2,491,375 242,138 

Business receipts 11,329,654 10,272,964 907,456 34,916 572,116 28,889 2,468,393 2,251,262 217,130 

Interest 749,790 450,538 29,989 1,470 14,231 2,248 156,145 149,343 6,802 

Other receipts 249,702 220,851 25,441 54 2,395 14 108,976 90,770 18,206 

Total deductions 8,857,516 7,633,561 725,763 28,429 461,716 23,126 1,355,276 1,194,906 160,370 

Cost of sales 6,497,471 6,033,023 613,986 23,765 411,224 20,105 715' 479 596,645 118,834 I 

Depreciation 214,055 129,468 10,425 413 3,188 324 40,200 37,207 2,993 ~ 

All other deductions 2,145,990 1,471 , 073 101,352 4,251 47,304 2,697 599,597 561,054 38,543 -I 

Estimated net income per return 3,471,630 3 , 310,789 237,134 8,011 127,026 8,025 1,378,237 1,296,469 81,768 

Estimated net income per books 3,292,876 3,131,757 223,943 4,652 124,448 7,960 1,331,046 1,234,393 96,653 

Distributions 2,381,677 2,261 , 848 80,780 600 30,939 2,097 624,242 595,916 28,326 
Number of corporations 

Total receipts 

Business receipts 

Nongovernment interest 

Other receipts 

Total deductions 

Cost of sales 

Depreciation 

All other deductions 

Estimated net income per return 

Estimated net income per books 

Distributions 

TABLE 4-4 - continued 

Manufacturing industries - continued 

Rubber I Leather and I Stone, clay, I Fabricated I Machinery, I Electrical and I 

and plastic leather and glass metal except electronic 

products products products products electrical equipment 

12 

71,123 

68,603 

1,472 

1,048 

53,920 

40,585 

1,641 

11,694 

17,203 

16,427 

4,226 

15 

184,754 

181,059 

3,159 

536 

156,890 

143,817 

1,106 

11,967 

27,864 

26,633 

1,870 

7 

17,019 

14,021 

926 

2,072 

12,774 

9,151 

266 

3,357 

4,245 

4,157 

332 

29 

203 ,172 

190,738 

7,506 

4,928 

150,521 

130,666 

6,318 

13,537 

52,651 

54,204 

21,962 

11 

159,017 

154,841 

3,808 

368 

120,228 

98,265 

1,419 

20,545 

38,789 

38,428 

2,120 

125 

2,707,540 

2,534,699 

149,804 

23,038 

1,791,192 

1,405,211 

32,648 

353,334 

916,348 

808,200 

1,236,405 

Instruments 

and related 

products 

34 

596,758 

556,236 

34,194 

6,328 

357,219 

263,517 

10,069 

83,634 

239,539 

242,988 

136 ,558 

I All other 

manufacturing 

47 

2,652,224 

2,560,987 

45,585 

45,652 

2,396,507 

2,157,252 

21,451 

217,804 

255, 717 

248,671 

119, 717 

I 

~ 

N 

I 
Number of corporations 

Total ReceiEts 

~usiness receipts 

Nongovernment interest 

Other receipts 

Total Deductions 

Cost of sales 

Depreciation 

All other deductions 

Estimated net income per return 

Estimated net income per books 

Distributions 

Department of the Treasury 

Off ice of Tax Analysis 

Nonmanuf act u ring 

total 

94 

1,384,796 

1,056,691 

299,253 

28,853 

1,223,955 

464,449 

84,588 

674,919 

160,841 

161,120 

119, 829 

TABLE 4-4 - continued 

Nonmanufacturinq industries 

I I Transportation, I I I communications, 

Construction and utilities Wholesale trade Retail trade 

7 5 23 7 

23,119 407,460 86,724 459,269 

21,643 399,769 86,376 455,883 

350 4,301 125 299 

1,126 3,390 223 3,086 

23,021 289,053 76,105 448,683 

14,090 4,167 56,272 351,645 

1,157 73,629 1,263 4,069 

7,774 211,257 18,570 92,969 

98 118 ,407 10,619 10,586 

-17 118,247 9,986 6,162 

0 114,830 326 1,592 

Finance, 

Insurance, 

real estate 

22 

326,496 

20,161 

293,291 

13,044 

310,455 

124 

2,282 

308,049 

16, 041 

22,113 

0 

I 

Other services 

and industries 

not reported 

30 

81, 728 

72,858 

886 

7,984 

76,638 

38,150 

2,188 

36,300 

5,090 

4,628 

3,082 

a Because firms electing the profit-split method did not report most of the income statement information, they are excluded from this table. 

I 

~ 

VJ 

I 
-44-

II. Estimated Tax Benefits in Tax Year 1983 

Table 4-5 shows the net income. possessions tax credits claimed , and estimated reduction 

in U.S. tax liability for all 625 possessions corporations for tax year 1983. The 

possessions credits claimed by all manufacturing corporations amounted to $1,824 million. 

This figure exceeds the estimated tax benefit received of $ l ,641 million. The tax benefit 

figure was estimated by applying to manufacturing possessions corporations the same U.S. tax 

rules which applied to corporations operating within the United States in 1983 (i.e., 

accelerated depreciation and the investment tax credit). and then subtracting from the 

tentative U.S. tax liability the income and tollgate taxes paid to Puerto l_lico. Puerto 

Rican taxes are subtracted out because, in absence of the possessions tax credit, a foreign 

tax credit would be pe1mitted. In calendar year 1983, Puerto Rico collected $136 million in 

tollgate taxes. It also collected $116 million in income taxes from 936 corporations 

operating under pa11ial income tax exemption grants. The pharmaceutical industry accounted 

for nearly half of the tax benefit, with the electrical and electronic equipment industry 

adding another 23 percent of the total. Other manufacturing industries each typically 

accounted for less than 5 percent of the total. 

The possessions credits claimed by nonmanufactuting companies amounted to $71 million. 

However. no tax benefit is attributed to those credits. It is assumed that 936 companies in 

nonmanufactming industries did not qualify for a Pue110 Rican tax exemption grant and that 

the taxes which they pay to Puerto Rico would. if viewed as creditable foreign income taxes. 

offset close to 100 percent of their U.S. tax liability. While the Pue110 Rican Industrial 

Incentive Acts provide exemptions to designated nonmanufacturing industries (in particular 

hotels. medical laboratories, movie production, and. after 1978, various services produced 

for export). the total possession income of possessions corporations in these industries was 

negligible in 1983. Moreover, a sample of the 1978 Puerto Rican tax returns filed by 

possessions corporations in all non-manufacturing industries suggests that the average 

effective Pue110 Rican tax rate for such companies was roughly 40 percent. This validates 

the assumption that Puerto Rican taxes would ofl\set nearly 100 percent of U.S. tax liability 

if a foreign tax credit (rather than a possessions tax credit) were applied. 

According to Table 4-5, four industry groups accounted for 83 percent of the tax benefits 

provided to possessions corporations: 

lndustI 

All industties 

Pharmaceuticals 

Elecfrical and electronic 

equipment 

Instruments 

Food and kindred products 

Reduction in U.S. tax liability 

($ million) 

$1,64 l 

760 

382 

115 

113 

Percentage 

of total 

100% 

46 

23 

7 

7 
-45-

TABLE 4-5 

NET INCOME, POSSESSIONS TAX CREDITS CLAIMED AND ESTIMATED 

TAX BENEFITS BY INDUSTRY, 1983 

($ million) 

All manufacturing industries $4,131 $1,895 $1,641 

Food and kindred products 279 128 113 

Textile mill products 6 3 3 

Apparel 123 56 51 

Chemicals 2,013 925 809 

Pharmaceuticals 1,888 867 760 

other chemicals 125 58 49 

Rubber and plastic products 29 13 12 

Leather 40 18 17 

Fabricated metal products 52 24 21 

Machinery, except electrical 41 19 17 

Electrical and electronic 

equipnent 1,008 461 382 

Instruments and related products 286 131 115 

All other manufacturing 254 117 101 

Nonmanufacturing 157 71 0 

Total $4,228 $1,966 $1,641 

Department of the Treasury Office of Tax Analysis 
-46-

It should he note<i that the net tax benefits ohtained hy Puerto Rican compAnies do not 

necessarily represent the amount of tax revenue that would immediately be transferred to the 

U.S. Treasury if section 936 were to be repealed. In the event of repeal, Puerto Rican 

companies could choose to stay in Puerto Rico or transfer to another low-tax foreign 

judsdiction and defer U.S. tax until dividends were repatriated to the U.S. Section VI 

discusses this issue in detail. 

III. Payroll and Employment in Tax Year 1983 

By enacting section 936 in J 976, Congress sought to assist Puerto Rico in obtaining 

employment-producing investments. Matching possessions corporations' U.S. income tax 

returns with payroll and employment data from the companies' federal unemployment insurance 

tax returns indicates whether this objective has been attained. Table 4-6 presents, by 

industry. section 936 tax benefits per employee and as a percent of labor compensation. 

(The actual tax benefits received by a possessions corporation depend on the amount of 

income earned, not on the number of workers employed.) Table 4-6 is based on 378 

possessions corporations in the manufacturing sector for which 1983 employment and payroll 

data could be obtained. The actual figures for those corporations are weighted up to 

represent the total 527 manufactming corporations by assuming that the relationships within 

each industry sector between employment and cost of goods sold (where available) or between 

employment and assets are the same for the complete group of 527 companies as for the 378 

companies for which employment and payroll data were available. See Appendix C for a 

discussion of the weighting procedure. The figures produced by the weighting refer to 

direct employment associated with section 936 companies. It is shown in section V that the 

indirect effects of section 936 on employment are likely to be small; furthermore, indirect 

effects are not generally included in the evaluation of tax provisions. 

Table 4-6 shows that, for manufacturing in general, the estimated federal tax benefits 

per employee averaged $18 .523. or 125 percent of the average compensation per employee. 

This percentage contrasts sharply with the 1982 figure of 148 percent. Tax benefits as a 

percentage of total employee compensation varied substantial1y from industry to industry. 

In the pharmaceutical industry the average federal tax benefits amounted to $57, 761 per 

employee. or nearly three times the average compensation of the comparatively well-paid 

Puerto Rican phatmaceutical employee. In the electrical and electronics industry the 

ave.rage tax savings amounted to $15 .005 per employee. or 96 percent of average compensation. 

In the apparel industry. by contrast. the average tax sayings per employee were $3 ,295, only 

one-third of employee compensation. 

Table 4-7 illustrates the distribution of tax benefits in relation to the number of 

employees. The chemical industry (primarily phaimaceuticals) was the only manufacturing 

sector in which the share of tax savings significantly exceeded the share of employment. 

Chemicals accounted for 49 percent of the benefits but only 17 percent of the employees. 

Within the chemical industry, the pharmaceutical industry provided 15 percent of the 

employment of all manufacturing companies and accounted for 46 percent of the total tax 

benefits. The electrical and electronic equipment industry accounted for 23 percent of tax 
TABLE 4-6 

TAX BENEFITS PER EMPLOYEE AND AS A PERCENT OF COMPENSATION, BY INDUSTRY, 1983 

All manufacturing industries 

Food and kindred products 

Textile mill products 

Apparel 

Men's and boy's 

W<;>men's and children's 

Hats, caps, etc. 

All other 

Cllemicals 

Industrial chemicals 

Pharmaceuticals 

Soaps, cleaners, etc. 

Other 

. Rubber and plastic products 

Leather products 

Footwear 

Other 

Fabricated metal products 

Cans and containers 

Other 

Machinery, except electrical 

Electrical and electronic 

equipment 

Radio, TV, communication 

Other 

Electronic components 

Instruments and related products 

Scientific instruments 

Other 

All other manufacturingc 

Department of the Treasury 

Office of Tax Analysis 

Actual data, 378 companies 

75,966 

7,167 

381 

13,514 

3,253 

5,998 

1,487 

2,776 

12,937 

712 

11,184 

446 

595 

986 

3,906 

3,609 

297 

1,254 

327 

927 

829 

22,002 

3,683 

8,355 

9,964 

8,577 

3,357 

5,220 

4,413 

Compensation 

($000) 

$1,122,785 

106,493 

3,634 

140,122 

36,207 

60,086 

14,953 

28,876 

277,594 

16,218 

244,178 

7,682 

9,516 

12,692 

41,662 

38,605 

3,057 

19,651 

5,294 

14,357 

13 ,403 

345,056 

50,480 

130,852 

163,724 

86,399 

4,661 

81,738 

76,079 

Employees a 

88,579 

8,098 

996 

15,628 

15,227 

13,149 

1,173 

4,720 

1,965 

843 

25,439 

12,649 

6,109 

Estimated totals, 527 companies 

Compensation a Average employee Tax 

Tax benefits 

benefits as a percentage of 

($000) compensation per employee e loyee compensation 

$1,314,182 $14,836 $18,523 124.8% 

123,132 15,205 14,003 92.1 

9,498 9,538 2, 720 28.5 

162,658 10,408 3,295 31. 7 

326,761 21,460 53,155 247.7 

286,961 21,823 57,761 264.7 

15,094 12,872 10,015 77.8 

50,369 10,672 3,567 33.4 

30,792 15,671 10,532 67.2 

13,629 16,168 20, 611 127.5 

398,352 15,659 15,005 95.8 

124,731 9,861 9,072 92.0 

102,937 16,851 16,476 97.8 

a The number of employees and the amount of compensation are estimated by weighting up the sample of 378 companies for which employment data were available. For those firms with cost-of-goods-sold amounts reported, the weight is the ratio of the total cost of goods sold for the industry to the cost of 

goods sold for the employment sample for the same industry. For firms with no reported cost of goods sold, the weight is the analogous asset ratio. 

b Tax benefit figures are shown in Table 4-5. c Includes paper; stone, clay, and glass; transportation; and manufacturing industries for which data were available for fewer than three corporations. 

I 

~ 

........ 

I 
1. 

-48-

henefits hnt provided 2Q percent of the employment of all manufacturing possessions corrorations. The next largest percentages of tax benefits were derived by the instruments and 

related products industries (7 percent of the tax benefits, 14 percent of the manufacturing 

employment) and the food industry (7 percent of the tax benefits and 9 percent of the 

employment). The apparel industry derived only 3. l percent of the tax benefits but 

contributed 18 percent of the manufacturing employment. 

Table 4-8 ranks by the amount of tax benefit per employee the corporations for which this 

info1mation is available. At the top of the ranking are sixteen companies for which the 

U.S. tax benefits represented $100,000 or more per employee in Puerto Rico. At the low end 

are the companies which incurred losses and therefore derived no immediate tax benefit from 

section 936. The top sixteen possessions corporations accounted for 24.2 percent of the tax 

benefits but provided only 3.6 percent of the employment of the 378 manufacturing companies. 

The top thirty-nine possessions corporations (those for which tax savings per employee 

equaled or exceeded $50.000 in 1983) collectively accounted for 48.6 percent of the tax 

benefits and 9. 7 percent of employment. 

Table 4-8 also presents a breakdown for only those firms eligible for the new tax 

treatment under TEFRA. For these 292 companies, the top twenty-seven (which had tax savings 

per employee of at least $50,000) accounted for 33.8 percent of the tax benefits and 8.1 

percent of employment. 

IV. Summary Data for 1974-1983 

Table 4-9 presents data for the period 1974-1983 on the number of possessions corporations, their net income, estimated tax benefits, and tax benefits in relation to payroll and 

employment. The data include the complete sample of the returns for all years, including 

1983. The table reveals a number of trends: 

0 

0 

0 

The number of possessions corporations in manufacturing was 399 in 1974 and 527 in 1983. 

Throughout the period 1974-83, the pharmaceutical industry and electrical and electronic 

equipment industry accounted for approximately 10 percent and 20 percent, respectively, 

of the total number of possessions manufacturing corporations. 

Net income of manufacturing possessions corporations rose from approximately $800 million 

in 1974 to over $4 billion in 1983. In constant dollars, net income in 1983 amounted to 

nearly 300 percent of income in 1974. The percentage of total net income earned by the 

pharmaceutical industry stood at approximately 50 percent through the period 1974 to 1982 

but dropped to 45 percent in 1983. The share of the electrical and electronics industry 

varied between 15 percent and 20 percent in years before 1981. In 1981. it rose to 26 

percent, in 1982 it was 22 percent, and in 1983 it was 24 percent. 

The estimated U.S. tax benefits of possessions corporations increased from $400 million 

in tax year 1974 to about $1.8 billion in tax year 1982, a change in inflation-corrected 

dollars of 255 percent. In 1983, tax benefits fell somewhat, to about $1.6 billion. 
-49-

TABLE 4-7 

DISTRIBUTION OF TAX BENEFITS AND EMPLOYMENT, 

BY INDUSTRY, 1983 

All manufacturing industries 

Food and kindred products 

Textile mill products 

Apparel 

Chemicals 

Pharmaceuticals 

Other 

Rubber and plastic products 

Leather 

Fabricated metal products 

Machinery, except electrical 

Electrical and electronic equipment 

Instruments and related products 

Other manufacturing 

Department of the Treasury 

Off ice of Tax Analysis 

Percentage of 

tax benefits 

100% 

6.9 

0.2 

3.1 

49.3 

46.3 

3.0 

0.7 

1.0 

1. 3 

1.1 

23.3 

7.0 

6.1 

Percentage 

em loyees 

100% 

9.1 

1.1 

17.6 

17.2 

14.8 

2.6 

1.3 

5.3 

2.2 

1.0 

28.7 

14.3 

2.2 

of 

SOURCE: The amount of tax benefits is from Table 4-5, column 3. 

number of employees is from Table 4-6, column 3. 

The 
-50-

TABLE 4-8 

TAX BENEFITS, EMPLOYMENT, AND COMPENSATION OF EMPLOYEES 

BY SIZE OF TAX BENEFITS PER EMPLOYEE, 1983 

Qualified 

Number possession Tax benefits Em>loyees 

of net income a Amount !Percent of Percent of 

returns ($ thousand) ($ thousand) total Number total 

ALL FIRMS 

All manufacturing 

corporations 378 4,059,624 1,406,406 100.0 75,966 100.0 

$100,000 or more 16 951,128 340,417 24.2 2,319 3.1 

$ 50,000 under $100,000 23 967,573 343,204 24.4 5,018 6.6 

$ 10,000 under $ 50,000 142 1,673,172 562,671 40.0 25,955 34.2 

$ 5,000 under $ 10,000 57 283,731 103,338 4.3 15,511 20.4 

$ 1,000 under $ 5,000 91 167,147 55,229 3.9 19,327 25.4 

$ 500 under $ 1,000 11 2,983 1,126 * 1,599 2.1 

$ 1 under $ 500 13 1,365 421 * 1,206 1.6 

No tax benefits 25 12,525 0 0 5,031 6.6 

FIRMS ELIGIBLE FOR TEFRA REQUIREMENI'S 

All manufacturing 

corporations 292 2,959,327 1,010,705 100.0 58,877 100.0 

$100,000 or more 10 550,004 198,553 19.6 1,354 2.3 

$ 50,000 under $100,000 17 688,492 245,305 24.2 3,488 5.9 

$ 10,000 under $ 50,000 115 1,364,772 449,380 44.5 21,638 36.8 

$ 5,000 under $ 10,000 45 195,452 69,759 6.9 9,979 16.9 

$ 1,000 under $ 5,000 71 144,819 46,578 4.6 15,902 27.0 

$ 500 under $ 1,000 8 2,226 810 * 1,227 2.1 

$ 1 under $ 500 9 1,037 320 * 923 1.6 

No tax benefits 17 12,525 0 0 4,366 7.4 

Department of the Treasury 

Off ice of Tax Analysis 

* Less than 0.5 percent 

a Equals net income from the active conduct of a trade or business in a possession plus net 

qualified possession source investment income. 
0 

0 

-51-

The U.S. tax benefits in relation to the number of employees in posst>s<\ions corporAtinns 

rose from about $6,300 per employee in 1974 to $20,699 per employee in 1982. Benefits 

per employee fell in 1983 to $18.523. 

The average compensation paid by 936 companies increased from $6.973 in 1974 to $14.836 

in 1983. However. tax benefits rose at a faster rate until 1982. Tax benefits grew from 

92 percent of compensation in 1974 to 148 percent in 1982. then fell to 125 percent in 

1983. 

V. Estimates of Linkages 

The preceding sections relate the tax benefits of the possessions corporation system of 

taxation to the employment and payroll of 936 companies. The employment and payroll of 936 

companies may overstate the direct benefits of the section 936 provisions for Puerto Rico 

because some of the workers would have been employed elsewhere. although probably at lower 

wages. On the other hand. the industry encouraged by this system of taxation may bring 

indirect benefits to Puerto Rico. The development of one industry may encourage the growth 

of other industries that are users of the products which it manufactures. a phenomenon 

called "forward linkages." Manufacturing also gives rise to "backward (supplier) linkages." 

Production requires raw materials, inte1mecliate goods. and services. a po11ion of which are 

supplied by the local economy; and investment in plants in Puerto Rico creates jobs in the 

construction industry. Finally. the wages earned by 936-company employees may generate 

greater consumption expenditures than there would be in the absence of section 936. which 

would increase the amount of employment in consumer-related industries. 

This report makes no attempt to estimate the indirect effects of section 936 because they 

are very difficult to evaluate. Forward linkages are weak because most 936 products are 

exported out of Puerto Rico. Backward linkages may exist. especially for services. but the 

service sector includes some 936 companies (which are counted in direct employment). 

Backward linkages to manufacturing films are primarily to 936 companies, where employment is 

counted in direct employment. Estimating consumer linkages is very speculative in nature 

because it requires a choice among competing macroeconomic theo1ies. In addition. any 

program that generates the same direct benefits as 936 in terms of disposable income will 

result in equivalent consumer linkages. Adding consumer linkages does not. therefore. 

contribute much to the assessment of the rnlative efficiency of section 936. 

A. Fon:vard Linkages 

"Forward linkages" are usually evaluated by examining the percentage of total sales to 

various types of customers. When one industry sells a substantial pa1t of its output to 

another local industry. forward linkages could occur. 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 imp01tant stimulant to the development of local 

"downstream" (customer) industries. 
TABLE 4-9 

SUMMARY DATA ON POSSESSIONS CORPORATIONS, 1974-1983 

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 

Number of corporations, all industries 596 595 528 519 637 672 709 635 620 625 

Manufacturing industries 399 394 395 385 460 502 458 497 502 527 

Pharmaceuticals 44 47 52 53 58 65 61 56 59 62 

Electrical and electronic equipment 76 76 81 80 90 112 116 120 119 134 

All other manufacturing 279 271 262 252 312 325 281 321 324 331 

Nonmanufacturing industries 197 201 133 134 177 170 251 138 118 98 

Net income, all industries ($000) 852,058 1,108,881 1,627,213 1,800,313 2,484,572 3,088,304 3,629,761 4,216,511 4,543,091 4,287,339 

Manufacturing industries 813,057 1,055,060 1,551,677 1,714,321 2,361,446 2,798,156 3,161,116 4,100,561 4,335,740 4,130,827 

Pharmaceuticals 405,355 547,060 779,954 876,576 1,053,252 1,325,309 1,507,001 1,867,684 2,228,390 1,887,903 

Electrical and electronic equipment 167,389 195,593 323,249 231,475 417,629 543,195 744,981 1,049,049 895,638 1, 007, 729 

All other manufacturing 240,313 312,407 448,474 606,270 890,565 929,652 909 ,134 1,183,828 1,211,712 1,235,195 

Nonmanufacturing industries 39,002 ~4,059 75,536 85,992 123,126 290,148 468,645 115,950 208,219 156,512 

Estimated tax benefits ($000) 

Manufacturing industries a 397,021 478,367 698,839 771,444 998,120 1,167,529 1,326,406 1,711,352 1,772,671 1,640,716 

Pharmaceuticals 181,508 245,486 350,941 394,459 438,695 552,020 626,376 791,535 905,996 759,517 

Electrical and electronic equipment 75,231 89,106 145,575 104,164 184,501 219,771 326,036 433,059 368,904 381,693 

All other manufacturing 140,282 143,819 202,322 272,821 374,924 395,738 373,994 486,758 497,771 499,506 

Tax benefits per employee, ($) 

Manufacturing industriesb 6,310 8,512 11, 454 11,217 14,250 15,690 17,297 18,007 20,699 18,523 

Pharmaceuticals 38,129 39,031 47,166 39,337 48,669 51,417 57,632 62, 078 69,751 57,761 

Electrical and electronic equipment 6,237 9,488 10,816 11,315 11,988 15,439 14,169 19,930 14,879 15,005 

All other manufacturing 3,479 3,987 5,300 4,432 9,639 8,415 8,943 8,584 10,401 9,957 

Tax benefits as a percentage of compensation of employees b Manufacturing industries 91. 7 116.1 143.3 135.9 133.2 135.4 145.2 137.9 148.3 124.8 

Pharmaceuticals 425.5 389.1 428.l 327.5 357.3 343.8 368.4 346.0 347.4 264.7 

Electrical and electronic equipment 93.5 126.0 129.2 126.6 122.6 138.9 126.1 152.3 108.4 95.8 

All other manufacturing 52.7 55.8 72.3 62.2 94.6 77.7 65.5 70.6 84.2 79.0 

Department of the Treasury 

Office of Tax Analysis 

a The estimated tax benefits shown here differ froa the corresponding years shown in Table 4-11 because that table is based on calendar and Federal fiscal years, 

whereas the data above are based on the tax years of possessions corporations. 

b These figures are weighted averages based on those returns for which employaent and compensation of employees were available. See Table 4-6 for details. 

I 

U'l 

N 

I 
-53-

The latest year for which detailed census data on the destination of Puerto Rican 

shipments are available is 1977. Some data are also available for 1982. Table 4-JO shows 

the percentages of manufacturing industries' shipments in 1977 and 1982 io 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 in 1982. 

18.6 percent of direct shipments went to Pue1to Rico, 74.2 percent to buyers (including 

parent companies) in the United States, and 7. 8 percent to foreign purchasers. If indirect 

shipments outside of Puerto Rico (i.e., goods sold to other Puerto Rican companies which are 

eventually sold to the United States or foreign countries) could be estimated separately, 

Puerto Rico's sales to the United States and foreign markets would be larger than in Table 

4-10. 

Table 4-10 shows that some industries· forward linkages with other sectors of the Puerto 

Rican economy are stronger than others. The stone. clay, and glass industry sells 80 

percent of its limited output to Puerto Rican users. The lumber and wood industry sold all 

its output to Puerto Rican consumers and industries in 1977. and its primary customers --

the furniture and paper industries -- also sold largely to the local market. By contrast. 

the chemical industry sold 9. 3 percent of total production to Pue110 Rico in 1982. and the 

electrical and electronic equipment industry sold 7. 3 percent to Pue1to Rico in 1982. These 

two industries. together with the consumer good industlies. apparel. and food products. 

account for over 80 percent of the business receipts of all possessions manufactuting 

corporations. The evidence of Table 4-10 would therefore suggest that possessions 

corporations are not generally an imp011ant stimulant to the development of "downstream" 

industries. There could be subsequent rounds of downstream effects not captured by the 

sales data of Table 4-10. but they are not likely to be quantitatively imp01tant. Further. 

downstream effects would not cause a multiplier effect on employment to the extent that the 

sales were to 936 companies. because the downstream employment would already be included in 

the employment and payroll figures of 936 companies discussed above. 

B. Backward Linkages 

Backward linkages refer to the generation of income and employment in "upstream" 

(supplier) industries as a result of an industry's purchases of local goods and services. 

The First Report on possessions corporations estimated that in most Pue110 Rican manufacturing industries, one-third to one-half of all materials were purchased from Pue110 

Rican sources. The usefulness of this data is limited. however. because it is based on 

input coefficients for 1963 and because it does not distinguish between purchases of 

materials from 936 manufactming companies and all other companies. 

The Puerto Rican government views the electronics industry as the centerpiece for 

expanding locally owned electronics. metal products. and plastics industries. Locally owned 

firms are increasing their sales of materials to 936 electronics firms. Pue110 Rico ·s 

apparel industry also obtains most of its inputs from locally owned companies. A substantial service sector in Pue110 Rico provides banking. transpo11ation. and utilities to 
TABLE 4-10 

DESTINATION OF SHIPMENTS BY PUERTO RICAN MANUFACTURING INDUSTRIES, 1977 AND 1982 

(percentages of known destination totals) 

1977 1982 

Industry Puerto United Foreign Puerto United Foreign a a Grou Rico States Countries Rico States Countries 

All Manufacturing Industries 33.4% 59.2% 7.4% 18.6% 74.2% 7.8% 

Food and kindred products 55.1 39.2 5.8 48.8 49.5 1. 7 

Tobacco products 45.3 54.7 * (D) (D) (D) 

Textile mill products 27.8 72.2 * (D) (D) (D) 

Apparel 18.6 76.3 * 9.3 89.3 1.4 

Lumber and wood products 100.0 * * (D) (D) (D) 

Furniture and fixtures 87.1 12.2 * 46.4 50.7 2.9 

Paper and allied products 87.6 4.0 8.2 73.0 (D) (D) 

Printing and publishing 53.8 44.4 1. 7 ( D) (D) 0.0 

Chemicals 9.2 74.2 16.6 4.0 84.3 11.7 

Pharmaceuticals 1.6 71.2 27.2 (D) (D) (D) 

Petroleum refining 68.9 28.7 2.4 (D) (D) (D) 

Rubber and plastic products 20.0 79.8 0.5 (D) (D) (D) 

Leather and leather products 2.5 97.2 0.1 ( D) (D) (D) 

Stone, clay, and glass products 83.8 15.3 0.8 80.4 16.5 3.1 

Primary metal industries 49.1 34.0 16.9 (D) (D) (D) 

Fabricated metal products 76.5 20.9 2.5 70.6 20.2 9.2 

Machinery, except electrical 27.8 71. 7 0.5 1.0 92.9 6.1 

Electrical and electronic equipment7.3 84.8 8.8 (D) (D) (D) 

Transportation equipment 9.1 84.6 6.2 ( D) 90.0 (D) 

Instruments and related products 0.4 95.4 4.1 (D) (D) (D) 

All other manufacturing 3.4 95.2 1.1 5.4 94.5 0.1 

Department of the Treasury 

Office of Tax Analysis 

SOURCE: U.S. Department of Commerce, 1977 Economic Censuses of outlying Areas, Manufactures, 

Puerto Rico, November 1980, u. s. Department of Conunerce, 1982 Economic Censuses of outlying 

Areas, Manufactures, Puerto Rico, November 1985. 

a 

* 

Figures for shipments to the United States represent direct exports by Puerto Rican manufacturing 

establishments to the United States and the U.S. Virgin Islands. 

Less than 0.05 percent. 

(D) Suppressed for disclosure reasons. 

I 

U\ 

~ I 
-55-

a11 936 manufacturing firms. Employment in these "supplier" industries is not included in 

employment figures reported in Table 4-6. Significant questions arise, however. from 

attempts to measure this backward linkage emp1oyment. 

Several studies have attempted to use Pue110 Rican input-output tables to estimate the 

indirect effect on the island of purchases by 936 corporation and services. For example. 

Dr. H. Calero concludes that 1.35 jobs are created indirectly for each 936 job.6 This 

employment multiplier is similar to the one used for Puerto Rican manufacturing by the 

Puerto Rican Government Planning Board in May 1985. Similarly. Fernando Zalacain used the 

Puerto Rico input-output table to find that employment multipliers for 936 companies in 

Puerto Rico range from 1.4 to 3.3 in major manufacturing industries. 7 

However, these mechanical applications of Puerto Rican input-output data to 936 

employment levels used to estimate indirect employment effects do not give valid results. 

Input-output tables are based on transactions between establishments. not corporations. 

Therefore. a shipment from a 936 corporation's bulk chemical plant to its final processing 

plant would be recorded as an indirect effect based on the input-output table, when in fact 

the enterprise·s entire employment is already included in the direct employment levels in 

Table 4-6. In addition. 936 corporations obtaining goods and services in Puerto Rico must 

frequently use other 936 corporations as suppliers simply because 936 corporations dominate 

many Puerto Rican manufacturing industries. Again, these "indirect" effects would have been 

counted in the Table 4-6 employment levels. The estimates of 936 indirect employment 

effects using conventional input-output tables therefore involve a substantial amount of 

double-counting and are seriously overstated. The studies that have attempted to correct 

for this double-counting do not seem entirely valid because of the limitations of the 

a procedures used. 

6 

7 

a 

Calero, H., Economic Challenges Facing Puerto Rico, Citibank Conference, March 1985. 

Zalacain, Fernando, "Los Multiplicadores del Sector Manufacturero 936 en la Economia de Puerto Rico". 

April 1985. 

The Puerto Rican Government Planning Board has recognized the difficulties inherent in using published input-output 

tables to estimate the indirect employment created by 936 operations and has calculated new employment multipliers 

that allegedly do not double count employment. ·These multipliers appear in Table 4 of a report prepared by 

Robert Nathan Associates titled "Section936andEconomicDevelopmentinPuertoRico" (August t 987). Although no 

supporting ~ata are provided in the report. the statements backing their findings seem unusual. The report claims 

that 936 firms generate employment in non-936 industries by purchasing non-labor inputs locally. The locally 

purchased inputs cited (on pp. 37-38) are chemicals, office supplies. packaging materials, and professional 

services, particularly finance, insurance, and real estate. However, the chemical industry in Puerto Rico is 

composed almost exclusively of 936 firms, and workers in the chemical industry are already counted under direct 

employment. In addition. the other three categories represent a very small proportion of the Puerto Rican economy 

and could not be responsible for the extraordinarily large numbers of workers that the report claims are indirectly 

affected by section 936. For example, Puerto Rican workers in finance. insurance. and real estate total only 

(Continued) 
-56-

C. Consmnption-Re1ated Linkages 

To the extent 936 employees' wages exceed alternative earnings, some indirect effect on 

local consumer-product industries might be associated with section 936. However, attempting 

to estimate the significance of these consumption linkages is very difficult because it 

requires choosing among a variety of alternative macro-economic theories. It is similar to 

the problem of forecasting the impact of a tax cut on GNP. Accordingly. this report focuses 

on direct benefits. which can be estimated from tax returns and other data, rather than 

indirect benefits, which are much more a matter of judgment and speculation. 

(Continued) 

28 ,000. Puerto Rican workers in paper and allied products (which includes packaging materials) total approximately 

40.000. some of which are counted in direct employment. The numbers generated by the Nathan report do not seem 

realistic in light of these facts. 

The methodology used to compute the employment multipliers in the Nathan report is also seriously flawed. leading 

the report to overstate multipliers substantially. According to correspondence received from Robert Nathan 

Associates (February 2. 1988), the input-output table was adjusted for double-counting. Each entry in the 

unadjusted table represents the impact of a given sector i on a given sector· j. For example, let sector 1 be 

.chemicals and sector 2 be printing and publishing. Entry (1, 2) would represent how an increase of output in the 

printing and publishing industry would lead to an increase in the output of the chemical industry, because 

chemicals are used in the production of printing and publishing products. Suppose the entry equals 0.1. Nathan 

Associates' consultants recognize that this entry must be adjusted because only a portion of the printing and 

publishing industry is 936 firms, and the interest lies with the effect of the 936 firms only. Therefore, they 

state that if the proportion of 936 firms to all firms in the printing and publishing industry is one-half, they 

would multiply the entry by one-half to come up with an adjusted entry (1,2). However, this adjustment procedure 

does not correct for the basic source of the double-counting in the multipliers. 

The error in their reasoning lies in their failure to recognize that the input industry is also part-936, part-non936 firms. For example, suppose the chemical industry is 100-percent 936 firms. Then the entry in table should be 

0, because there can be no backward linkage into the chemical industry. All the chemical industry's employment 

would already be counted in the direct employment figures. However, according to their correspondence, Nathan 

Associates completely disregarded this necessary adjustment. Nathan Associates also apparently adjusted for 

indirect employment effects resulting from consumption but did not explain how this was done. 

A further memorandum from Fernando Zalacain has not entirely clarified matters. It does not specify whether the 

necessary adjustments were made on the direct requirements matrix, as is necessary, or the inverse. Furthermore, 

it does not indicate whether the adjustments reflect the special nature of 936 operations. He claims that if the 

whole manufacturing sector were assumed to be 936, the 936 manufacturing multiplier would only be reduced by 18 

percent. First, this is not entirely to the point because some 936 corporations may perform their own warehousing. 

distribution and transportation services. In addition. most 936 products are not marketed in Puerto Rico and 

require few local retail or wholesale services. The 18 percent reduction also seems modest when compared with U.S. 

input-output tables. It is hoped that Treasury and Puerto Rican Government staffs will resolve these problems 

before the next possessions report. 
-57-

VI. Revenue Impact of Section 936 

A. Revenue Estimates and Estimating Procedure 

Table 4-1 l presents the estimated U.S. tax benefits provided by the possessions 

corporation system for calendar and fiscal years J 973-1983. It is necessary to apportion 

the income reported on corporate returns filed for corporate tax years which overlap the 

federal fiscal year. This results in an estimate of $1. 619 million in tax benefits under 

section 936 for calendar year J 983 (and of $1.633 million for fiscal year 1983). 

As noted previously. the section 936 tax benefits for tax year J 983 are estimated by 

first subtracting from the qualified income of possessions corporations the additional 

deductions and credits which these corporations would have enjoyed had they been eligible 

for the accelerated cost recovery system and the investment tax credit, and then applying 

the U.S. statutory tax rate to the adjusted qualified income. The revenue estimate is then 

reduced by the tollgate and income taxes paid to Puerto Rico. 

For accounting periods beginning after December 31, 1982, possessions corporations are 

subject to the provisions of section 936(h), added to the Internal Revenue Code by TEFRA. 

Section 936(h) provides that only certain income from intangibles developed by a U.S. 

corporation may be allocated to an affiliated possessions corporation. The remainder of 

the income from such intangibles must be allocated to the rest of the U.S. group. Because 

of the complexity of section 936(h) and the uncertainty in the interpretation of prior law 

relating to the allocation of income from intangibles, many of the 1983 returns did not 

report income correctly. Furthennore, the new tax fonns reflecting the changes in section 

936 made by TEFRA were not available until mid-J 983. Therefore. many calendar-year taxpayer 

filed on unrevised tax f01ms. As a result, the 1983 figures are tentative. This issue will 

be discussed in detail in the next chapter. 

In addition to the rules relating to income from intangibles, TEFRA reduces the amount of 

passive investment income that a corporation can receive and still qualify for the 

possessions tax credit. Under law applicable to tax years beginning in 1982, a possessions 

corporation could receive up to 50 percent of its gross income in passive investment income. 

This was reduced to 45 percent for tax years beginning in 1983, 40 percent for tax years 

beginning in 1984. and 35 percent for tax years beginning in 1985. The 1986 Tax Refonn Act 

reduced the percentage to 25 percent. These reductions affect only those corporations which 

currently earn passive income in amounts close to the current limit. Because the passive 

investment income earned by most possessions corporations is well below 50 percent of their 

gross income. the revenue effect of the passive income limitation under TEFRA is expected to 

be small. 

B. Alternative Tax-Saving Routes 

Whether the elimination of the possessions corporation e:xemption would result in a gain 

to the U.S. Treasury of the tax benefits provided under section 936 depends on the taxsaving alternatives available to possessions corporations and on the induced effect on the 
Year 

1973 

1974 

1975 

1976 

1977 

1978 

1979 

1980 

1981 

1982 

1983 

-58-

TABLE 4-11 

FEDERAL REVENUE COST ESTIMATES, 

POSSESSIONS CORPORATION PROVISIONS, 1973-1983 

(millions of dollars) 

Calendar Year 

Recei ts Fore one• 

269 

393 

473 

692 

763 

988 

1,156 

1,233 

1,694 

1,643 

1,619 

Fiscal Year 

Recei • ts Fore one 

254 

325 

429 

572 

724 

864 

1' 121 

1,195 

1,463 

1,668 

1,633 

Department of the Treasury 

Office of Tax Analysis 

a Estimates for 1973 through 1975 are based on the 

original possessions corporation provisions enacted in 

the Revenue Act of 1921. Estimates for 1976 to 1982 are 

based on the section 936 provisions of the Tax Reform 

Act of 1976. Estimates for 1983 are based on the 

provision of TEFRA. 

Source: The 1973 through 1975 figures are based on book 

income data taken primarily from 936 election forms 

filed for 1976 (Form 5712). The 1976 and 1977 

estimates are based on net income data taken 

primarily from Federal income tax forms (Form 

1120). The figures for 1978-1983 are based on 

qualified possession taxable income . taken from 

possessions credit computation forms (Form 5735). 
-59-

aggregate level of investment by U.S. persons. The relative tax advantages of a Puerto 

Rican location vary for physical and financial investments and for the use of intangible 

assets. 

9 For tax reasons, Puerto Rico can be a more attractive location than the United 

States for plant and equipment and other operating assets. But these advantages may not be 

significantly better than those available in a low-tax developing country. On the other 

hand. Puerto Rico under section 936 offers unique advantages for financial assets. such as 

deposits and bonds, and for the use of certain intangible assets. 

1. Physical assets 

If section 936 was not available, a possessions corporation could still obtain the 

benefit of U.S. tax exemption on current income from physical assets by remaining in Puerto 

Rico as a Puerto Rican chartered corporation or by moving to a foreign country, because the 

foreign earnings of a corporation incorporated outside the United States are generaJly not 

subject to U.S. tax until the earnings are repatriated to the United States. Where a U.S. 

parent corporation derived foreign-source income, the U.S. tax on that income could be 

reduced by a credit for foreign income taxes paid. 

If a possessions corporation derived most of its income from investment in physical 

assets, it might elect to reincorporate in Pue110 Rico or in a foreign country if section 

936 were repealed. For firms taking this course, the repeal of the possessions corporation 

food products, apparel, and fabricated metal products. 10 In 1983, the combined income of 

possessions companies in low-technology industries represented only 8 percent of the income 

of all 936 manufacturing corporations. 

2. Financial Assets 

In the absence of section 936, a possessions corporation could have still benefited from 

U.S. tax exemption on income from financial assets in 1983 by incorporating in Puerto Rico 

and deferring distribution of the earnings to the United States (provided that it met the 

tests of section 957(c) by deriving 80 percent of its gross income from sources within 

Puerto Rico or a U.S. possession and 50 percent or more of its gross income from the active 

9 "Physical investment" consists of expenditures. to buy newly produced capital goods, plants, equipment, and 

inventories. "Financial investment" means the purchase of securities, such as stocks and bonds and certificates of 

deposit (CDs). Some "intangible assets," such as patents and know-how, are produced by investment in research and 

development and training; other intangibles, such as trademarks, acquire value because of expenditures on 

advertising and promotion. 

1

° For a discussion of the relative shares of possessions corporations· income from physical and intangible assets. 

see the Fourth Report, pp. 61-66. Low-technology industries are defined as those industries where R&D as a 

percentage of capital spending and of sales is below the average for all U.S. manufacturing industries. 

Low-technology industries include textiles; stone, clay, and glass products; paper; and rubber products; as well as 

those industries mentioned in the text. Industry data are for 1982, from Annual McGraw-Hill Survey of Business· 

Plans for Research and Development Expenditures, 1982-85, Tables IV and V. 
-60-

conduct of any of the enumerated trades or businesses). Income from financial assets 

represented over 15 percent of total 936 income in 1983. The Tax Reform Act of 1986 

repealed section 957(c) for tax years starting in 1987. so income from financial assets of a 

Pue110 Rican subsidiary would now be taxed currently under subpart F if section 936 were I 

repealed. 

3. Intangible Assets 

Income from intangible assets generally refers to income derived from patents. know-how. 

trademarks. brand names. access to established marketing and distribution ~hannels. and 

goodwil I. Before the enactment of TEFRA. many U.S. parent corporations transferred 

intangibles (tax-free) to affiliated possessions corporations. which in tum claimed as part 

of their income the return attributable to the intangibles. As explained in Chapter 2. 

TEFRA provides that 936 corporations which meet a significant business presence test in a 

possession are eligible for tax exemption on ce11ain income from intangibles developed by 

their affiliates. 

In the absence of section 936, income from intangibles developed or purchased by a U.S. 

corporation would. in general. be fully subject to U.S. tax regardless of whether the 

intangibles are used in the United States or abroad. U.S. law as amended by the Deficit 

Reduction Act of 1984 provides that. in the case of an otherwise tax-free transfer of 

intangible property from a U.S. person to a foreign corporation, the transferor is treated 

as receiving an annual payment equal to the value of the intangible in that year. Such 

deemed payments are U.S. -source income .

11 This provision is intended to retain the U.S. 

taxing authority over income from an intangible even if transferred to a foreign 

corporation. The Fourth Report estimated that. in tax year 1980, roughly 50 percent of the 

income of 936 manufacturing corporations may have been a return on intangibles developed or 

purchased by an affiliated corporation.12 Although TEFRA has reduced the tax benefits 

derivable from intangibles, the benefits were still large in the tax year covered by this 

report. While these benefits may be further reduced somewhat because of the provisions of 

the Tax Reform Act of 1986, available data suggest that repeal of section 936 could have a 

substantial tax revenue impact. 

11 Under pre-1984 law. a U.S. corporation which transferred to a foreign corporation the U.S . rights to an intangible 

was required to include in the transferor's gross income the fair market value of the intangible, less the adjusted 

basis in the hands of the transferee, which was normally zero. Such income would be subject to tax. However. in 

general. no tax was imposed on the transfer by a U.S. corporation of the foreign rights to an intangible if the 

intangible was used in. foreign manufacture. The special treatment of transfers of foreign rights to intangibles 

was eliminated by the Deficit Reduction Act of 1984. 

12 See Fourth Report, pp. 61-66, 128. 
Chapter 5 

EFFECTS OF THE TEFRA LEGISLATION 

I. Introduction 

This report is the first to contain taxpayer data from returns filed after the TEFRA 

provisions become effective. This chapter explores. as far as possible, the effects TEFRA 

seemed to have had on 936 companies. For several reasons, primarily concerned with data 

r. quality, conclusions are tentative. The main contribution of this chapter is setting up a 

d framework for future reports and speculating on the possible effects TEFRA had. 

d 

1 The General Explanation of the Revenue Provisions of the Tax Equity and Fiscal 

~esponsibility Act of 1982 called attention to the unduly high revenue loss attributable to 

a allocation of intangible income to possessions corporations (particularly in comparison with 

y average wages paid in Puerto Rico) before the passage of TEFRA. This chapter takes a first 

look at the effectiveness of the TEFRA provisions in reducing the revenue loss relative to 

wages paid. 

~ This chapter contains several frequency tables~ which break down firms by method of 

t filing (cost-share or profit-split) and evaluate the change in the tax-benefit to 

f compensation ratio across industries and across methods. Companies with manufacturing 

J intangibles (such as firms selling ethical pha1maceuticals, electrical and electronic 

equipment, and instruments) tend to select the cost-share method. Those with marketing 

intangibles such as trade names (for example, fitms in the food and beverage industry and in 

the over-the-counter drug industry) adopt the profit-split method. All firms using a 

specified method experienced a drop in the tax-benefit to compensation ratio. Although the 

level of the ratio was much greater for profit-split films both before and after TEFRA. the 

percentage fall in the ratio was also much greater, being 33.3 percent for profit-split 

finns and 12.5 percent for cost-share firms. 

The relatively greater effect of the legislation on profit-split firms also shows up in 

the tax credits per worker ratio, which falls by nearly a quarter for profit-split firms but 

rises for cost-share firms. The annual growth in income (other than QPSII) per company from 

1974 to 1982 was approximately 19. 8 percent. (Note that this figure does not correct for 

changes in firm size.) Income fell by about I 0 percent from 1982 to 1983. The concomitant 

fall in tax credits may therefore be partly attributable to the TEFRA changes. 

-61-
-62-

II. The Data 

Taxpayers were required to follow TEFRA rules for allocating the income of possessions 

corporations if their tax year began on or after January 1, 1983 .

1 Because this sample 

contains 122 firms with tax years ending after June 30, 1983 and before December 31, 1983, 

only the remaining 405 firms were eligible for the TEFRA treatment. 

Although Table 5-1 shows that 77 percent of 1983 firms qualified for TEFRA rules, an 

inspection of the returns as filed leads to the impression that only about half of those 

eligible actually appeared to comply with the new law. 2 This may have happened partly 

because the 1983 tax forms were issued late in 1984, so many companies originally filed on 

out-of-date forms. Fu11hermore, the TEFRA provisions are complicated, and not all taxpayers 

may have understood the provisions in the first year after enactment. 

A. Frequencies By Method of Filing 

Table 5-1 reports the breakdown of all 1983 firms by type of method used in filing the 

tax return. It also presents data on a sample of 456 firms for which information from both 

1982 and 1983 tax years was available ("matched 1982-1983 firms"). Of the 527 total firms. 

77 percent were eligible for the TEFRA rules; these firms accounted for 73 percent of 

assets. Of the 405 eligible firms, 42 percent used the cost-share method, 13 percent used 

the profit-split method, and 45 percent did not clarify which method was used. 3 The 

respective percentages by assets are 37, 20. and 16. The percentages were similar for the 

matched firms. 

B. Frequencies by Industry 

Tables 5-2 and 5-3 present industry breakdowns by type of method used. The percentages 

in Table 5-2 are to be read across rows, so that the proportion of a particular industry 

using. for instance, the cost-share method can be deduced. For example, 34 percent of 

pha1maceutical companies used the cost-share method; these companies held 44 percent of the 

assets in this industry. The percentages in Table 5-3 are read down columns, so that the 

1 

2 

3 

Some taxpayers seemed to have rearranged their filing years. filing part-year returns with accounting: periods 

January 1. 1982. toDecember30, l 982andfull-yearreturnswithaccountingperiodsDecember 31, 1982 .. toDecember 

30. 1983. 

Note that a 936 company is eligible for an exemption from the TEFRA rules by statute with respect to intangible 

property that has been licensed to it since 1948 (Code section 936(h)(3)(A)). 

Some taxpayers used different methods for different products. A total of 26 firms used both profit-split and 

cost-share methods in 1983, and 24 "matched" firms used both methods in 1983. Approximately 42 percentofincome 

was attributable to cost-share products. Therefore, the figures for the 170 total "cost-share" firms represent an 

imputation: 159 firms that used only the cost-share method. plus 42 percent of the twenty-six firms (approximately 

eleven firms) that used both methods. 
-63-

TABLE 5-1 

FREQUENCIES BY METHOD OF FILING 

Percentage Percentage Assets Percentage Percentage 

Number of total of eli ible ($ billion) of total of eli ible 

ALL 1983 FIRMS 

Total 527 100% $17.3 100% 

Eligible 405 77% 100% $12.6 73% 100% 

Cost-share method 170 32 42 6.4 37 51 

Profit-split method 53 IO 13 3.4 20 27 

Unknown 182 35 45 2.8 16 22 

Ineligible 122 23% 4.8 27% 

MATCHED 1982-1983 FIRMS 

Total 456 100% $16.0 100% 

Eligible 348 76% 100% J I. 7 73% 100% 

Cost-share method 149 33 43 6.1 38 52 

Profit-split method 45 10 13 3.3 21 28 

Unknown 154 34 44 2.3 14 20 

Ineligible 108 24% 4.4 27% 

Department of the Treasury 

Office of Tax Analysis 
-64-

proportion of firms using a pa11icular method that is represented by a given industry is 

shown. For example. 9 percent of cost-share firms hy number and 36 percent hy a~set were in 

the pha1maceutical industry. 

As mentioned previously, one would expect industries with substantial marketing 

intangibles to use the profit-split method. because this method allows the possessions 

corporations to obtain pa11 of the return on the intangibles while the cost-share method 

does not. Industries with large manufacturing intangibles would be expected to choose the 

cost-share method because the entire return from such intangibles can be allocated to the 

possessions corporation under this method. 

Table 5-2 shows that the food (including beverages) industry tended- toward the 

profit-split method. with profit-split users accounting for 44 percent of the assets in the 

industry. The marketing intangibles associated with food and beverage products make the 

profit-split method a logical choice. Films manufactuiing instruments and electrical and 

electronic equipment tend to use the cost-share method. with cost-share users accounting for 

76 and 70 percent. respectively. of attributable assets in those indust1ies. Both 

industries have substantial manufacturing intangibles. so their choice of the cost-share 

method is not surprising. Chemical films. including pharmaceuticals, were about evenly 

split between profit-split and cost-share products. Again, this is not surprising. The 

pha1maceutical industry produces both prescription drugs, which would tend to be cost-share 

products because they have substantial manufacturing intangibles, and over-the-counter 

chugs. which would tend to be profit-split products because they have marketing intangibles. 

The apparel industry had more than half its assets ineligible for TEFRA, while the apparel, 

fabricated metal, and food industries had substantial amounts of business that apparently 

did not file under a TEFRA method. (The chemical and instruments industries had a higher 

fraction of companies that appeared to comply with the TEFRA changes, perhaps because the 

size of the fitm is larger and such industries tend to have more sophisticated tax 

depa11ments.) 

Table 5-3 shows that the chemical industry accounted for 46 percent of manufacturing 

assets and 70 percent of assets attributable to profit-split products. The electrical and 

electronic industry accounted for 21 percent of manufacturing assets and 3 7 percent of 

assets attributable to cost-share products. 

C. Tax Benefit and Employment Information, By Method 

Table 5-4 presents a breakdown by method of filing for the manufacturing firms for which 

it was possible to match 1982 and J 983 data. It reports possessions tax credits, credits 

per possessions corporation worker, estimated tax benefits. estimated compensation. and the 

ratio of benefits to compensation for each method. 

Total credits fell by 27. 9 percent for profit-split finns and 31.4 percent for films 

which did not repo11 a filing method. In contrast. credits rose by 6.9 percent for 

cost-share films and 12. 7 percent for firms ineligible for TEFRA treatment in 1983. In 
TABLE 5-2 

FREQUENCIES BY METHOD OF FILING, BY INDUSTRY, ALL 1983 FIRMS 

($ million) 

Percentages of total Percentages of eligible 

I Total Ineligible I Eligible Cost-Share I Profit-Split I Unknown 

I No. 

All manufacturing 527 

Food and kindred 

products 24 

Apparel 82 

Chemicals 99 

Pharmaceuticals 62 

Fabricated metal 

products 29 

Electrical and 

electronic equipment 134 

Instruments and 

related products 42 

Other 117 

Department of the Treasury 

Office of Tax Analysis 

I Assets 

$11, 320 I 

I 

1,240 I 

579 I 

1 ,977 I 

1 ,381 I 

I 

310 I 

I 

3 ,6691 

1,041 I 

2 ,498 I 

No. I % I Assets I % 

122 23% $4,758 27% 

3 13 280 23 

29 35 303 52 

25 25 2,215 28 

18 45 2,187 30 

10 34 116 37 

20 15 330 9 

11 26 165 16 

24 21 1,348 54 

I No. I % I Assets I % No. I % I Assets I 

405 77% $12,563 72% 169 42% $6,353 

21 87 960 77 5 24 154 

53 65 276 48 10 19 54 

74 75 5,762 72 23 31 2,495 

44 55 5,200 70 15 34 2,308 

19 66 194 63 5 26 70 

114 85 3,339 91 75 66 2,351 

31 74 882 84 17 55 672 

93 79 1,150 46 34 37 557 

% I No. I % I Assets I % I No. I % I Assets 

51% 54 13% $3,397 27% 182 45% 2,814 

16 4 19 425 44 12 57 382 

20 0 0 0 0 43 81 222 

43 27 36 2,393 42 24 32 875 

44 18 41 2,212 43 11 25 680 

36 0 0 0 0 14 74 124 

70 8 7 335 10 31 27 653 

76 6 19 159 18 8 26 50 

49 9 10 85 7 50 54 508 

I % 

22% 

40 

80 

15 

13 

64 

20 

6 

44 

NOTE: Percentages should be read across rows. For example, the percentage of ineligible firms (by number) plus the percentage of eligible firms (by number) for 

each row sum to 100 percent. In addition, the sum of the percentage of cost-share firms (by number) the percentage of profit-split firms (by number), and 

the percentage of unknown firms (by number) equals 100 percent for each row. The same relationship applies to the asset percentages. "Eligible" firms 

are ones with taxable years such that the TEFRA change apply to them. 

As an example, 55 percent of pharmaceutical companies were eligible to file under the TEFRA rules; 70 percent of assets in pharmaceutical firms belonged 

to eligible companies. Of the eligible pharmaceutical firms, 34 percent used the cost-share method, 41 percent the profit-split method, and 25 percent 

used unknown methods. The assets attributable to each method were 44 percent, 43 percent, and 13 percent. 

I 

°' Vt 

I 
-66-

these same categories, credits per worker fell 23.5 p,ercent, fell 20.4 percent, rose 6.1 

percent, and rose J 9. 3 percent, respectively. Note that the comparison across years does 

not necessarily indicate an effect from TEFRA. The relevant comparison would be credits (or 

credits per worker) under TEFRA and in the absence of TEFRA. The latter is clearly 

unobservable. However. provided that income continued growing as it did from 1974 to 1982. 

credits would have increased in the absence of TEFRA. Therefore, at least the profit-split 

and unknown-method firms appeared to have been affected by TEFRA. Tax benefits for each 

eligible category fell (most markedly in the profit-split and unknown companies), while they 

rose for ineligible films. 

Table 5-4 indicates that the ratio of tax benefits to compensation decreased from 13 7 

percent to 10 I percent in companies required to use the TEFRA provisions. In contrast, tax 

benefits in relation to compensation increased sharply in companies not eligible for the 

TEFRA rules. 

D. Tax Benefit and Employment Information, By Industry 

Table 5-5 breaks down matched films by industry and reports possessions tax credits. 

credits per worker. estimated tax benefits. estimated compensation. and the ratio of 

benefits to compensation. Table 5-6 presents tax credits and tax benefits for firms that 

were eligible for TEFRA treatment in 1983 and were matched to 1982 tax records. 

Total credits fell 6.9 percent for all firms and by 12.1 percent for eligible firms. The 

aggregate numbers mask industry differences, however. The chemical industry took 12.5 

percent fewer credits in 1983 for all firms and 25.5 percent fewer for eligible firms. The 

elect1ical and electronic industry had 4.6 percent more credits for all firms and 4.1 

percent more for eligible firms. In the instruments industry, total credits rose by 4.3 

percent for all films and 2.8 percent for those eligible. 

In general. tax benefits fell in all major industry categories. Particularly notable is 

the 28.2 percent fall in tax benefits in the chemical industry's eligible companies. In the 

electtical and electronics industry. tax benefits fell 9. l percent, and in instruments they 

decreased by 7. 8 percent. Table 5-4 indicates that for the companies with matched 1982 and 

1983 returns the ratio of tax benefits to compensation declined from 13 7 percent to 1 O I 

percent in eligible fitms as a whole while it increased sharply for companies not using the 

TEFRA rules. 

III. Analysis 

The info1mation to be obtained from these data is sketchy at best. A few observations 

may neve11heless be made. From Table 4-9. we can deduce that reported income per fitm in 

manufacturing industries rose from $2.037. 700 in 1974 to $8.637.000 in 1982. then fell to 

$7.838.000 in 1983. The annual average growth rate from 1974 to 1982 was 19.8 percent and 

from 1982 to 1983 was -10.2 percent. If nothing had changed between 1982 and 1983 or if the 
I 

I 

All manufacturing 

Food and kindred products 

Apparel 

Chemicals 

Pharmaceuticals 

Fabricated metal products 

Electrical and electronic 

equipment 

Instruments and related 

products 

Other 

Department of the Treasury 

Office of Tax _Analysis 

TABLE 5-3 

PERCENTAGES BY INDUSTRY FOR EACH FILING CATEGORY 

ALL 1983 FIRMS 

Total IneJigible I Eligible Cost-share I Profit-split 

Number! Assets Number I Assets I Number I Assets Number I Assets I Number! Assets 

1003 1003 1003 1003 1003 1003 1003 1003 1003 1003 

5 7 2 6 5 8 3 2 7 13 

16 3 24 ~ 13 2 6 I 0 0 

19 46 20 47 18 46 14 39 50 70 

12 43 15 46 11 41 9 36 33 65 

6 2 8 2 5 2 3 I 0 0 

25 21 16 7 28 27 44 37 15 lO 

8 6 9 3 8 7 lO 11 11 5 

22 14 20 28 23 9 20 9 17 I I 

I Unknown 

I Number I Assets 

1003 1003 

7 14 

24 8 

13 31 

6 24 

8 4 

17 23 

4 2 

27 18 

NOTE: Percentages should be read down columns. For example, 19 percent of all manufacturing firms were in chemicals but 46 

percent of all manufacturing assets were owned by chemical firms. Furthermore. although 19 percent (by number) of all 

firms were chemical. 50 percent (by number) of profit-split firms were chemical. The percentages by asset are 46 for all 

firms and 70 for profit-split firms. "Eligible" firms are ones with taxable years such that the TEFRA changes apply to 

them. 

I 

O'I 

......) 

I 
Number 

All manufacturing 456 

Eligible 348 

Cost-share 149 

Profit-split 45 

Unknown 154 

Ineligible 108 

Department of the Treasury 

Office of Tax Analysis 

TABLE 5-4 

TAX BENEFIT AND EMPLOYMENT INFORMATION 

FOR MATCHED FIRMS, BY :METHOD 

Estimated Estimated 

Tax credits tax credits Tax benefits compensation 

( $ million) per worker ($ million) ($ million) 

1982 1 1983 1982 I 1983 1982 I 1983 1982 I 1983 

l ,879 l,758 22,308 21,914 l ,717 l ,505 l, 172 l .214 

l,455 1.279 20,767 20,997 l,329 1,086 968 l,070 

698 746 21,244 22,549 642 631 502 563 

438 316 45, 150 34,558 398 265 179 179 

318 218 14,651 l l .667 290 190 287 328 

424 478 21,481 24,755 387 418 204 144 

Estimated benefit/ 

compensation 

(%) 

1982 I 1983 

147 125 

137 IOI 

128 112 

222 148 I 

IOI 58 a-. 

00 

I 

190 290 
Number 

All manufacturing 456 

Food and kindred products 18 

Apparel 75 

Chemicals 85 

Pharmaceuticals 53 

Fabricated metal products 27 

Electrical and electronic 

equipment 118 

Instruments and related 

products 35 

Other 98 

Department of the Treasury 

Office of Tax Analysis 

TABLE 5-5 

TAX BENEFIT AND EMPLOYMENT INFORMATION 

FOR MATCHED FIRMS, BY INDUSTRY 

Estimated Estimated Estimated 

Tax credits tax credits tax benefits compensation 

($ million) per worker ($ million) ($ million) 

1982 I 1983 1982 I 1983 1982 I 1983 1982 I 1983 

l.879 1,758 22,380 21,914 l,717 1,505 l,172 1,214 

85 80 15, 110 10,908 78 69 72 63 

41 54 2,584 3,815 38 49 144 140 

991 867 65,514 62,872 892 748 309 305 

930 818 72,874 68,693 840 706 255 273 

22 23 10,078 12.921 19 20 30 29 

410 429 16.839 18,621 357 345 334 343 

117 122 16,994 10,649 106 105 94 115 

213 183 15,275 21, 110 227 169 189 219 

Estimated benefit/ 

compensation 

(3) 

1982 I 1983 

147 124 

108 110 

26 35 

289 245 

329 259 I 

°' \0 

I 

63 70 

107 100 

113 91 

120 77 
TABLE 5-6 

TAX BENEFIT INFORMATION FOR MATCHED ELIGIBLE FIRMS, BY INDUSTRY 

Tax credits Tax Benefits % Change 

($ million) ($ million) in Tax Benefits 

Number 1982 I 1983 1982 I 1983 1982 to 1983 

All manufacturing 348 1,455 1,279 1,329 1,086 -18.3 

Food and kindred products 17 81 80 74 69 - 6.8 

Apparel 47 19 26 17 24 41.1 

Chemicals 63 737 549 662 475 -28.2 

Pharmaceuticals 35 677 500 611 434 -28.9 

Fabricated metal products 18 111 13 9 11 22.2 I 

-...J 

Electrical and electronic 0 

I 

equipment 101 388 404 359 326 - 9.1 

Instruments and related 

products 25 108 111 103 95 -7.8 

Other 77 111 96 105 86 -18.1 

Department of the Treasury 

Office of Tax Analysis 
-71-

time trend of rising income had stayed constant absent TEFRA, these figures would indicate 

that the TEFRA legislation substantially reduced the amount of income that possessions 

corporations could effectively exempt from U.S. tax. 

The reported income and credit figures thus would seem to indicate that TEFRA had a 

substantial effect on the amount of income possessions corporations may effectively exempt 

from U.S. tax. Several caveats must be made. however. A recession occurred in 1982. which 

might have contributed to a downturn in income. Investment income {such as QPSII) fell 

partly because interest rates fell. Changes in firm composition could also have affected 

the aggregates in absence of legislative change. A change in the number of workers or their 

productivity could certainly have affected total credits. and the credit-per-worker numbers 

reported in the last section reflect different percentage changes {even. in some cases. 

different signs) than the credit numbers. 

In spite of these caveats, some information may be extracted from Tables 5-1 to 5-6. Net 

income grew every year from 1974 to 1982, even though business cycles may have caused the 

growth rate to vary from year to year. Net income undeniably fell in J 983. Credits 

certainly fell more for eligible firms than for fitms overall (although credits per worker 

did not change much for either group). Credits. benefits, and the benefit/compensation 

ratio all fell for eligible firms and rose for ineligible firms. Profit-split firms seem to 

have been substantially more affected by the legislation than cost-share fitms, although 

profit-split firms continued to have a greater ratio of tax benefits to employee 

compensation. Finally, certain industries (such as chemicals) which used the profit-split 

method tended to have relatively large reductions in tax benefits. 

This analysis is not comprehensive, principally because the data do not stand up to much 

empirical testing. In the future. a more reliable dataset may become available, and a more 

rigorous analysis isolating the effects of the TEFRA legislation may be possible. Only the 

most tentative statements about these data can be made at this time: that TEFRA appears to 

have reduced the amount of income possessions corporations may effectively exempt from tax. 

with profit-split firms relatively more affected. 
CHAPTER 6 

THE IMPACT OF 936 FINANCIAL ASSETS ON PUERTO RICAN INVESTMENT 

- RECENT DEVELOPMENTS -

I. Introduction 

This section reviews recent developments in the continuing attempt by the Puerto Rican 

government to use the financial assets retained in Puerto Rico by 936 corporations to promote Pue110 Rican development. Table 6-1 presents the financial po11folios of all 936 

corporations in Pue110 Rico at the end of 1986. Although the growth has been moderate in 

recent years (i.e .. from a total of $10.6 billion at the end of 1983 to $14.7 billion at the 

end of I 986). the size of these financial investments is nevertheless enormous for an 

economy the size of Puerto Rico·s. They amount to more than $4,000 for each person living 

on the is land. 

The goal of the Puerto Rican government· s efforts has been to use these financial assets 

to reduce the cost of capital in Puerto Rico compared to that in world capital markets and 

thereby to stimulate real investment on the island. This chapter first reviews the changes 

in the Puerto Rican regulations governing the use of 936 funds since the beginning of 1984. 

It also summarizes the provisions of the Tax Reform Act of 1986 which apply to financial 

investments by 936 corporations. It then attempts to evaluate the impact of the financial 

investments by 936 corporations in Pue110 Rico by looking at three ways in which this impact 

would be visible. One is through an increased net inflow of capital into Pue110 Rico. 

Another way of tracing the role of 936 funds is noting their relationship with the level of 

real investment in Pue110 Rico. In addition, the forces determining the interest rate paid 

on 936 funds are described. because a low rate relative to world capital markets creates the 

oppo11unity for 936 funds to have a beneficial impact on Puerto Rico. 

II. Recent R gulatory and Statutory Changes 

To ensure that increasing financial investment in Puerto Rico by 936 corporations leads 

to increased real investment on the island, it is necessary to separate the market for 936 

funds from world capital markets by preventing arbitrage between them. The Puerto Rican 

government has therefore since 1976 issued a series of rulings and regulations which have 

progressively limited the discretion of financial institutions in using 936 funds. These 

rulings and regulations identify assets the acquisition of which constitutes "eligible" uses 

of 936 funds by financial institutions. They also specify the financial investments by 936 

corporations that have to be matched with eligible assets held by financial institutions. 

and how the matching is implemented. For example. they give the base period for the 

calculation of incremental eligible assets and incremental eligible 936 funds. This section 

reviews regulatory developments from the end of 1983 through the end of 1986. 

-73-
-74-

TABLE 6-1 

ESTIMATED COMPOSITION OF THE FINANCIAL INVESTMENTS 

OF POSSESSIONS CORPORATIONS AT YEAR-END 1986a 

Financial investments $ billion 

Total ...................................... . 1S.2b 

Investments in Puerto Rico, total ........ . 

Deposits in Puerto Rican banks, 

including repurchase agreements 

Repurchase-Resale agreements not 

included in banks funds .............. . 

Puerto Rican source GNMA mortgages 

Loans to other possessions 

corporations ......................... . 

Puerto Rican government 

obligations .......................... . 

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 

14.7b 

8.8c 

. 8 

2.2 

.Sb 

.Sb 

1. Sb 

.4b 

Department of the Treasury 

Office of Tax Analysis 

a 

b 

c 

Some of the funds referred to as 936 deposits may include 

deposits by exempt firms which have not made a 936 election, 

e.g., local exempt firms. These, however, are likely to be a 

small part of the total. 

The financial assets listed do not include accounts receivable 

or other working capital. 

Denotes approximation. 

This includes about $1.6 billion in savings banks, mostly 

obtained indirectly through brokers. 
-75-

A. The April 17, 1984 Regulations 

The Puerto Rican regulatory system governing the use of 936 funds was basically unchanged 

from the time of implementation of the April 17, 1984, regulations until March 1, 1988 when 

Regulation 35 82 was issued. By far the most important change brought about by the April 17, 

1984, regulations is the linking of the interest paid on 936 funds and the amount of 

eligible assets a bank or broker is required to generate. If banks or brokers pay interest 

on the 936 funds that is less than 65 percent of the comparable Eurodollar rate, the 

required amount of eligible activity is just equal to the amount of 936 funds received. 

However, if the 936 rate is 65 percent or higher, the eligible activity has to exceed the 

amount of 936 funds received. with the penalty increasing as the interest rate rises. The 

complete schedule is: 

Interest rate on 936 funds 

as a percentage of 

the Eurodollar rate 

0 to 64.9 

65 to 69.9 

70 to 74.9 

75 to 79.9 

80 to 84.9 

85 to 89.9 

90 and upwards 

Eligible Activity 

to be generated per 

dollar of 936 funds 

$1.00 

$1.05 

$1.15 

$1.22 

$1.36 

$1.54 

$2.00 

The purpose of this penalty schedule (or "tablita") is to drive down the interest rate on 

936 funds by restricting the ability of banks or brokers to bid for funds when rates are 

high. 

B. The Tax Reform Act of 1986 

As indicated in Chapter 2. the Tax Reform Act of 1986 made two changes in rules that 

apply to qualified possession source investment income. One change increased the share of a 

936 corporation's gross income that has to be derived from the active conduct of a trade or 

business in a possession from 65 to 75 percent. (A three-year moving average continues to 

be used to evaluate the percentage.) Accordingly, 936 corporations will be required to 

limit their qualified possession source investment income to less than 25 percent of their 

gross income. 

Section 936(d) provides that qualified possession source investment income must be 

"att1ibutable to the 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." The 

Tax Reform Act of 1986 extended the "for use therein" requirement to include investment 

through a Puerto Rican financial institution in a qualified Caribbean Basin country. 
\' 

- - - - -- - - --- - - - - - - --- _-::::.........: 

-76-

Catibbean Basin countries can qualify as eligible sites for such investments by enteting 

into a tax inf01mation exchange agreement with the United States. The investment by the 

Puerto Rican financial institution in the qualified Catibbean Basin country must finance 

either active business assets or development projects in accordance with specific 

authorization granted by the Pue110 Rican Government. 1 

At the time of the Tax Refo1m Act of 1986, only Barbados was a qualifying Caribbean Basin 

country. Since that time, Jamaica, Grenada. and St. Lucia have also entered into tax 

info1mation exchange agreements that qualify them as eligible sites for such investments. 

The Conference Committee Repo11 to the 1986 Act noted the conferees· expectation that the 

Government of Pue110 Rico would make a good faith effort to carry out the twin plant 

initiative outlined in a draft Memorandum of Agreement between the Government of Pue110 Rico 

and the Government of the United States dated November 14. 1985. 2 That Agreement described 

Puerto Rico's goal of generating $100 million of new private direct investment annually in 

Ca1ibbean Basin countries. These funds were anticipated to be derived. without additional 

cost to the United States Treasury, from a variety of sources, including possessions 

corporations (in exchange for future Pue110 Rican tax concessions). funds of the Government 

Development Bank for Puerto Rico, and grants by the Government of Puerto Rico. 

C. Brief Summary of Regulation 3582 

Puerto Rican Regulation 3582 became effective on March 1. 1988 and replaced the 

regulation enacted in Aptil 1984. 

One of the major changes made by regulation 3582 .was to penalize banks who used a large 

portion of their non-936 Pue110 Rican deposits to invest in offshore assets. The Pue110 

Rican government recognized that the QPSI I provisions do not fulfill their goals if the 

availability of 936 funds simply frees Puerto Rican banks t_o use their "normal" sources of 

funds to invest outside of Puerto Rico. Accordingly, if a financial institution's ratio of 

Puerto Rican (noneligible) assets (such as consumer loans) to local non-936 funds is less 

than 80 percent, additional eligible activity has to be generated per dollar of eligible 936 

funds. The penalty starts at 10 percent and increases up to a maximum of 25 percent for 

banks with a Puerto Rican asset/liability ratio of less than 60 percent. These additional 

requirements are over and above the '~tablita" first introduced in 1984 and slightly revised 

in regulation 3582. 

Regulation 3582 also changed the percentage of eligible funds that financial institution 

had to invest in Puerto Rican government obligations. Under the new regulations. 15 percent 

of eligible assets have to be in deposits with the Government Development Bank or in Puerto 

1 

2 

The Tax Reform of 1986 required such authorization to come from the Government Development Bank for Puerto Rico. 

The Technical and Miscellaneous Revenue Act of 1988 substitutes the Commissioner of Financial Institutions of 

Puerto Rico as the authorizing. agency. 

H. Report 99-841, Vol. II, p. 634 
-77-

Rican government obligations not exempt under section 103 of the U.S. Internal Revenue Code. 

A fu11her 1-2 percent must he loaned to the new Economic Development Bank. In addition. at 

least 7 percent of eligible assets must be invested in specified types of eligible assets 

including loans to finance projects in a qualified Cruibbean Basin country, loans to 

rehabilitate low and middle income housing and loans to tourism hotels. 

Finally. 3582 provides incentives for CBI loans. For example, a financial institution 

can reduce its required eligible activities by 25 percent of the principal amount of loans 

for active business assets or development projects in a qualified Caribbean Basin country. 

III. Net Capital Inflows Into Puerto Rico and 936 Funds 

One indication of the success of the Qualified Possession Source Investment Income 

(QPSII) provision has been successful in increasing investment in Puerto Rico can be found 

in the capital account component of the Pue110 Rican balance of payments. Real investment 

in any economy can be financed by (a) private domestic saving. (b) government saving, or (c) 

capital inflows from abroad. The QPSII provision was intended to increase the third source 

of capital. inflows from abroad. The objective was first to cause the large pool of funds 

that had been invested in the Eurodollar market under section 931 to flow back into Puerto 

Rico. In addition, 936 corporation would have the incentive to reinvest their earnings in 

Pue110 Rico. Any increase in this source of investment would be reflected in a change in 

net capital inflows into Pue110 Rico. This section reviews the relationship between 

increased financial investments in Puerto Rico by 936 corporations and net capital inflows. 

In addition, because increased real investment is the ultimate goal of the QPSII provision, 

the relationship between 936 financial investment and real investment in Puerto Rico is 

examined. 

Table 6-2 gives an overview of the net contribution of capital inflows, including the 

accumulation of 936 funds, to the financing of real investment in Puerto Rico. The change 

in available 936 funds is reflected in the first row of the table, which gives changes in 

assets in Pue110 Rico of corporations controlled outside Puerto Rico. These assets include 

operating assets such as plant and equipment as well as financial investment. but most of 

the substantial variations in direct investments are attributable to changes in the 

accumulation and repatriation of 936 funds. (Balance sheet data in past reports, of the 

type presented in Table 6-1 in this report, indicate that the year to year changes in gross 

depreciable assets and inventories held by 936 corporation are relatively modest and are 

usually on the order of $100 million per year.) The bottom row of Table 6-2 is the overall 

level of net inflows into Pue110 Rico, i.e.. the sum of all positive and negative 

contributions. In the eight years from 1974 through 1981, the level of net capital inflows 

in Pue1io Rico was very stable, ranging from $1. 3 billion to $1. 9 billion per year. In 

addition. this stable level of net flows seems to have been unrelated to the large swings in 

foreign direct investment that reflected the variations in the inflow and accumulation of 

936 funds. In 1982 and 1983. net inflows declined to very low levels. This paralleled the 

sharp decline of private real investment in Puerto Rico (given in Table 6-3) and the large 

liquidation of inventories in particular. Direct investment inflows decreased very sharply 
TABLE 6-2 

COMPONENTS OF THE PUERTO RICO CAPITAL ACCOUNT, 1974-1986 

($ million) 

[(+) 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.] 

Year Endin2 June 30 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 

Direct investment in Puerto Rico - change 

change in the assets of corporations 

(mainly 936's) controlled offshore 735 625 1,483 1,698 1,702 1,164 2,048 2,215 577 1,306 1,001 4,050 1,011 

Net short-term banking flows 39 306 59 -544 -211 -337 -694 -1,362 -655 -871 1,586 -2,249 -36 

Foreign holdings of bank debts 64 474 -12 -87 -15 330 -108 -355 172 -338 396' 275 69 

Investment by Puerto Rican banks abroad -25 -168 70 -457 -197 -667 -586 -1,007 -827 -533 1,190 -2,524 -105 

Net foreign investment in long-tena 

Puerto Rican Government obligations 590 900 184 352 -156 690 423 166 462 949 478 -93 320 

Puerto Rican investment in U.S. 

Government securities 113 13 -29 -310 -132 -190 13 -114 -260 -423 -458 -67 I 124 .....J 

00 

I 

Other investments of public 

pension funds -1 8 l -4 -19 -32 -63 -38 33 -17 -82 10 -88 

Net foreign investment in short-tern debts 

of .Puerto Rican publ'ic corporations 15 153 -37 111 -13 -5 141 -14 67 -17 103 11 -198 

Short-term investment abroad by Puerto 

Rican government corporations -21 -88 -25 -48 -249 -322 -255 395 -425 -730 -610 316 -52 

Miscellaneous short term investment abroad 

by the Puerto Rican private sector -54 -93 4 19 17 54 -2 -29 -39 -9 -530 164 233 

Federal loans to Puerto Rico farm sector 29 35 47 71 134 172 143 133 146 94 47 120 64 

Drafts on Puerto Rican importers held 

for collection 54 -40 21 -46 49 24 5 -23 -7 52 3 93 105 

All other -87 109 -55 53 121 33 -193 137 83 121 238 23 45 

Total: Net 1,412 1,900 1,653 1,352 1,499 1,309 1,583 1,593 128 618 1,811 1,987 1,337 

Department of the Treasury 

Off ice of Tax Analysis 

SOURCE: Puerto Rico Planning Board, Bureau of Economic Accounts and Censuses 
TABLE 6-3 

ANNUAL GROSS DOMESTIC INVESTMENT IN PUERTO RICO, 1973-1988 

($ million) 

Current Dollars 

Private 

Residential and Government 

Fiscal year Total Change in Nonresidential Machinery and and public 

(Ending June 30) Total private inventories Construction equipment enterprises 

1973 l,793 1,226 192 599 435 567 

1974 1,799 l, 138 104 659 375 661 

1975 2,218 l, 183 139 646 398 1,035 

1976 1.974 l, 196 138 576 482 778 

1977 l,499 873 -61 442 492 626 

1978 1,870 1.255 125 561 569 615 

1979 2.063 1.318 176 531 611 745 

1980 2,458 1.569 407 505 657 889 

1981 2.265 1,312 126 515 671 953 

1982 1,246 416 -542 483 475 830 

1983 1.429 759 -230 432 557 670 

1984 2.392 1,595 417 527 651 797 

1985 2.296 l,435 37 549 849 861 

1986 2~012 1,279 -308 564 1,023 733 

1987 2,914 1,.895 -2 737 l, 160 1,019 

1988p 3,677 2,303 50 908 1,345 1,374 

Department of the Treasury 

Office of Tax Analysis 

SOURCE: Economic Report of the Governor of Puerto Rico~ 1986, Puerto Rican Planning Board. 

l 954 Dollars 

Gross Private 

Fixed Investment 

563 

305 

436 

433 

375 

415 I 

...J 

390 \0 

I 

363 

330 

250 

256 

292 

352 

401 

457 

523 . 
-80-

in 1982 as wen, which is consistent with modest increase in 936 funds in 1982 indicated in 

the Fifth Report. This parnllel movement of 916 funds and net capitnl inflows in a 

recession suggests that real investment demand in Puerto Rico can influence the flows of 936 

funds. Whether the causation also runs in the opposite direction. from 936 funds to real 

investment, remains an open question. 

In the three years from 1984 through 1986. net capital inflows returned to the levels of 

the 1972-1981 period. Again this tracked the recovery in Puerto Rican investment that is 

evident from Table 6-3. Furthermore, the pattern visible in previous years was again 

apparent in that the level of net capital inflows was largely unrelated to the changes in 

direct investment by 936 companies, which reflect changes in 936 funds. For example. the 

very large growth of direct investment of more than $4.0 billion in fiscal 1985 compared to 

1984 is barely visible in the change in net inflows. The various other components of the 

capital account tended to offset the changes in 936 funds. For example. the large increase 

in the assets of 936 corporations in 1985 was largely offset by a $2.2 billion doJlar 

outflow of short term funds through the Puerto Rican banking system. The large outflow of 

funds in the form of short-term investments offshore by Puerto Rican government corporations 

continued in 1984 although there was a modest reduction in holdings in 1985. In addition. 

in the three years from 1983 through 1985 the Puerto Rican government corporations acquired 

almost $1.0 bi11ion of U.S. government long-te1m securities. (This was a period in which 

the Puerto Rican government was raising substantial funds offshore.) At the end of June 

1986, Puerto Rican public corporations held $2.2 billion of sho11 te1m assets offshore and 

$ 1. 8 billion of long-term U.S. government securities. (This number does not include 

holdings of public employee pension funds.) In addition, the private Puerto Rican banks 

held offshore bank deposits and sho11-te1m U.S. government securities of $5.4 billion. This 

compares with a total amount of 936 funds in banks of $8.8 billion. 

· One development since 1983 is that short term holdings offshore, including the United 

States, by the Puerto Rican nonbanking private sector have made a larger contribution to 

changes in overall inflows and outflows. Table 6-2 indicates that short term (non U.S. 

Treasury) investments offshore by the private sector increased by more than $500 million 

dollars in 1984 and then most of these funds flowed back in 1985 and 1986. 

While it is very difficult to make precise estimates of the impact of 936 funds on real 

investment ill Puerto Rico, the basic investment data in Table 6-3 shed some light on the 

issue. They indicate that from 1980 to 1986 ptivate investment in nominal terms was. at 

best. only slightly above the level in .the early 1970's before the enactment of the present 

QPSII provision in section 936. The 1ight hand column of Table 6-3 indicates that private 

real fixed investment in 1983-86 averaged only 70 percent of the investment in 1973-5. 

Prior to 1976 passive investments by possessions corporations could be held offshore. The 

very large accumulation of 936 funds in the Puerto Rican financial institutions began as a 

result of the 1976 legislation. In spite of the fact that no 936 funds were available. a 

much higher level of real private investment was financed in the early 1970's than in the 

fi'rst ten years after the enactment of the QPSII provision. The fact that most of the 

fluctuations of total private· investment since 1976 have been attributable to cyclical 

changes in inventories also suggests that the availability of 936 funds has not had a major 

impact on Puerto· Rican growth. 
-8 lIn 1987 and 1988. real private fixed investment increased strongly, but it is difficult 

to attrihute this to the QPSII provision. Much of this growth in private investment may 

have been by the 936 corporations themselves, not the users of 936 funds. One reason for 

doubting that the strong recent growth in investment is due to 936 funds is that the Tax 

Refo1m Act of 1986 limited QPSII benefits. In addition. as indicated in the next section, 

the discount of the interest rate on 936 funds from Eurodollars has been smaller recently 

then in other periods in the 1980.s. Furthermore. there was virtually no growth in total 

available 936 funds in 1986 and 1987. It is therefore unlikely that the QPSII provisions 

could have had a very stimulating effect in 1987 and I 988. 

IV. Eligible Assets and the Interest Rate on 936 Funds 

The April 17. 1984. regulations promulgated by the Puerto Rican Treasury were intended to 

dtive down the interest rate on 936 funds compared to world rates by linking the level of 

eligible assets required to be held by financial institutions to the interest rate paid to 

936 corporations. As shown in the "tablita" in section 6-1, a substantial penalty in te1ms 

of the requiremem of additional eligible activity has to be paid if interest rates are 65 

percent or more of the comparable Eurodollar rates. These additional requirements for 

eligible assets make it difficult for banks and brokers to bid for 936 funds as interest 

rates on 936 funds rise. 

Table 6-4 presents data on the 936 funds and eligible assets in all commercial and 

savings banks from January 1984 to June 1987. Column three of Table 6-4 gives the amount of 

additional eligible assets required because of the penalties imposed by the April 17, 1984, 

regulations. Table 6-5 gives the interest rate paid on 936 funds compared to Eurodollars. 

Table 6-5 indicates that the April 1984 regulations had the immediate impact of driving 

down the rate on 936 funds. from about 85 percent of Eurodollars to about 70 percent. 

However. as in previous episodes in which regulations were tightened, such as the April 1980 

and February 1982 changes described in earlier reports, the effect was only temporary. 

After averaging about 75 percent of the Eurodollar rate in 1985, the 936 rate rose to an 

average of about 84 percent of Eurodollars in 1986. or where it had been in March 1984 

before the April 1984 regulations. The rate on 936 funds then averaged 81. 9 percent of the 

Eurodollar rate in the first 6 months of 1987. At these differentials the cost of capital 

in' Pue110 Rico could be 1.0 to 1.5 percentage points below world rates. 

Table 6-4 indicates that 936 funds in banks grew at the rate of about $1.5 billion per 

year through 1984 and 1985. At the same time, eligible assets in banks continued to grow at 

the rate of about $2.0 billion per year in calendar 1984 and 1985. (This was equal to 

almost 100 percent of the level of aggregate public and private. residential and non 

residential gross investment annually in Puerto Rico in 1984 and 1985. This is somewhat 

surprising because nonbank financial investments by 936 corporations are not included in the 

total and other sources of funds such as depreciation allowances are presumably also 

available to finance new gross investment. The aggregate investment data also includes 

investment of the 936 corporations themselves, presumably not requiring financing by Puerto 
-82-

Rican banks. The growth of eligible assets in 1984 and 1985 therefore suggests that the 

regulations were not very effective in restricting the use of 936 funds.) Accordingly, 

eligible activities increased by about $1.0 billion relative to 936 funds from the beginning 

of 1984 to the end of 1985. 

There were apparently large repatriations of 936 funds at the end of 1985 and again at 

the end of 1986. Furthermore. the rate of accumulation of funds during calendar 1986 seems 

to. have declined. As a result, the level of 936 funds in banks in June 1987 was about the 

same level as June 1986, and was only about $0.5 billion above the level in June 1985. 

Eligible activities grew by about $1.0 billion in 1986. While this rate of growth was less 

than in previous years. the fact that 936 funds were virtually flat in 1986 meant that the 

gap between eligible activities and funds continued to widen. In the first half of 1987 

both 936 funds and eligible activities were virtually unchanged from the end of 1986. 

The rapid growth of eligible assets relative to 936 funds in 1984, 1985, and J 986 made it 

possible for banks to offer high interest rates on 936 funds in spite of the additional 

investment in eiigible assets required as a result of the penalty provisions of the April 

1984 regulation. The growth in these additional asset requirements is clear in column three 

of Table 6-4. The amount of excess eligible assets, given in the last column of Table 6-4. 

has been relatively stable and usually fluctuates in a range of between $700 million and 

$1.200 million. Most of these excess eligible assets are in the smaller local commercial 

banks and savings banks. For example. the federal savings banks accounted for $804 million 

of the aggregate of $1,074 miJlion of excess eligible assets in June 1987. The additional 

risk premium that has to be paid in order to "mobilize" the assets in the smaller local 

banks (in the form of additional collateral or compensation to brokers for guarantees) means 

that a substantial level of overall excess eligible assets is consistent with market 

equilibrium. The cost of 936 funds to the largest banks is 1.0 to J.5 percentage points 

cheaper than non-936 funds. A relatively small risk premium would therefore eliminate any 

advantage of 936 funds. 

One question is why 936 funds in Pue1to Rican banks stopped growing after the fall of 

1985. The substantial decline in world interest rates in 1986 may have played a role. Even 

though the 936 rate was much higher relative to the Eurodollar rate in 1986 compared to 

1985. it was still down in absolute terms. U.S. corporations may simply have chosen to hold 

fewer financial assets at these low rates. 

The Tax Reform Act of 1986 may also have had a significant effect. Three provisions are 

particularly relevant for the holding of passive financial assets in Pue1to Rico. One 

directly applicable item is the increase in the percentage of 936 gross income that has to 

be derived from an active trade or business rather than from financial investments. In 

addition. the new rules on the allocation of interest expense to foreign-source income could 

reduce · the benefits of exempt interest income in Pue1to Rico if the parent corporation has 

to increase borrowing in the United States. The U.S. parent corporations may choose to 

repatriate 936 funds in order to hold down their interest expense which would in pa1t have 

to be allocated to foreign income. (Because of the 3 year phase-in of the application of 
-83-

T ABLE 6-4 

936 FUNDS AND ELIGIBLE ACTIVITIES OF ALL COMMERCIAL AND SAVINGS BANKS 

(monthly averages in millions of dollars) 

Year and 

month 

1984 

January 

February 

March 

April 

May 

June 

July 

August 

September 

October 

November 

December 

1985 

January 

February 

March 

April 

May 

June 

July 

August 

September 

October 

November 

December 

1986 

January 

February 

March 

April 

May 

June 

July 

August 

September 

October 

November 

December 

1987 

January 

February 

March 

April 

May 

June 

t'unels requiring investment in eli- Incremental eligible activities gible activities 

6,087 

6,429 

6,387 

6,519 

6,904 

6,907 

6,899 

7,141 

7,185 

7,119 

7,303 

7,230 

7,467 

7,626 

7,676 

8,046 

8,209 

8,249 

8,268 

8,607 

8,631 

8,829 

9,022 

8,460 

8,075 

8,151 

8,368 

8,547 

8,603 

8,744 

8, 777 

8,791 

8,881 

8,961 

9,083 

8,333 

7,810 

8,024 

8,389 

8,648 

8,532 

8, 776 

6,846 

7, 114 

7,125 

7,383 

7,469 

7,621 

8,057 

8,345 

8,390 

8,445 

8,565 

8,641 

8,938 

9,104 

9,539 

9,735 

9,899 

10,074 

10,056 

10,221 

10,425 

10,553 

10,761 

10,766 

10,819 

10,829 

10,997 

11,038 

11, 127 

11, 271 

11, 269 

11, 314 

11, 493 

11, 573 

11, 646 

11, 657 

11, 602 

11, 604 

11, 644 

11, 702 

11, 686 

11,676 

Department of the Treasury Off ice of Tax Analysis 

SOURCE: Government Development Bank 

~!igible activities 

required 

as penalties 

0 

0 

0 

0 

89 

120 

339 

155 

417 

706 

692 

678 

766 

512 

810 

904 

828 

952 

1,002 

849 

817 

1,014 

897 

1, 118 

1,588 

1,643 

1,679 

1,596 

1,626 

1,691 

1, 729 

1,590 

1,609 

1,695 

1,502 

1,760 

2,220 

2,366 

2,079 

1,993 

1,895 

1,825 

Excess eligible activities 

760 

685 

738 

864 

475 

593 

819 

1,047 

788 

618 

568 

732 

704 

966 

1,053 

784 

861 

872 

786 

764 

977 

710 

842 

1,187 

1,206 

1,034 

949 

894 

898 

836 

763 

933 

1,004 

917 

1,060 

1,563 

1,571 

1,214 

1,175 

1,060 

1,257 

1,074 
--

-84- . 

TABLE 6-5 

936 INTEREST RATES VS. OTHER SHORT TERM RATES 

(three month rates) 

Ratio of 936 rate 

Year and Eurodollar rates Rate on to Eurodollar 

month 3-months Prime rate 936 funds (percentage) 

1984 

January 9.78 11.00 8.36 85.5 

February 9.91 11.00 8.38 84.6 

March 10.40 11. 21 8.79 84.5 

April 10.83 11. 93 8.20 75.7 

May 11.53 12.39 7.99 69.3 

June 11.68 12.60 8.36 71.6 

July 12.02 13.00 8.36 69.6 

August 11.81 13.00 8.53 72.2 

September 11.67 12.97 8.74 74.9 

October 10. 77 12.58 8.80 81. 7 

November 9.50 11. 77 7.90 83.2 

December 8.90 11.06 7.10 79.8 

' 1985 

January 8.37 10.61 6.30 75.3 

February 9.05 10.50 6.50 71.8 

March 9.32 10.50 7.00 75.1 

11 

April 8.74 10.50 6.60 75.5 

May 8.13 10.31 6.40 78.7 

June 7.60 9.78 6.20 81.6 

July 7.89 9.50 5.90 74.8 I August 8.02 9.50 5.70 71.1 

September 8.14 9.50 6.00 73.7 

October 8.08 9.50 5.90 73.0 

November 8.02 9.50 5.90 73.6 ~ December 7.99 9.50 6.50 81.4 ,, 

11 1986 " . 

' 

I January 8.02 9.50 6.60 82.3 

February 7.89 9.50 6.50 82.4 

March 7.42 9.10 6.20 83.6 

April 6.80 8.80 5.80 85.3 

" May 6.86 8.50 5.60 81.6 

June 6.93 8.50 5.60 80.8 I 

. July 6.54 8.16 5.50 84.1 ' 

I August 6.06 7.90 5.10 84.2 

September 5.86 7.50 5.10 87.0 

· October 5.87 7.50 4.90 83.5 ,

", ' November 5.96 7.50 4.90 82.2 ~ December 6.25 7.50 5.50 88.0 

1987 

January 6.10 7.50 5.40 88.5 

February 6.32 7.50 5.30 83.1 

March 6.37 7.50 5.30 83 . 2 

April 6.73 7.75 5.40 80.2 

May 7.25 8.14 5.50 78.9 

June 7 .11 8.25 5.50 77 .4 

Department of the Treasury 

Office of Tax Analysis 

SOURCE: Government Development Bank 
--... 1 

-85-

the interest allocation rule. its impact in early 1987 was probably relatively small.) 

Finally. dividends from a 916 corporation wi11 he included in the parent corporntion 's 

alternative minimum tax base as pa11 of the book income provision. This may have caused 

increased repatriations in 1986 before the 1987 effective date of the alternative minimum 

tax. It may also result in a smooth pattern of repatriations in the future because 

unusually large dividends might trigger the minimum tax. 

V. Conclusions 

The April 1984 regulations seem to have had little if any success in further reducing the 

cost of 936 funds relative to world interest rates. It is also very difficult to identify 

any substantial impact of 936 funds in stimulating additional real investment in Puerto Rico 

or contributing to a net inflow of capital. The inflow of 936 funds seems to be related to 

cyclical swings in inventory investment in Puerto Rico but otherwise the changes in 936 

funds do not seem correlated with changes in plant and equipment spending or with overall 

net capital flows into Puerto Rico. The sincere and comprehensive effort by the Puerto 

Rican Government to exploit the benefits of 936 funds appears not yet to have achieved any 

very visible results. The most recent phase in this effort, regulation 3582, will be 

evaluated in the next possessions rep011. 
Appendix A 

OPERATION OF THE POSSESSIONS CORPORATION SYSTEM OF TAXATION 

IN AMERICAN SAMOA, GUAM, THE COMMONWEALTH OF THE 

NORTHERN MARIANAS AND THE VIRGIN ISLANDS 

The term "possession" as used in section 936 of the Internal Revenue Code includes not 

only Puerto Rico but also American Samoa, Guam, and other smaller U.S. territories .

1 It 

did not include the Virgin Islands before 1987. Beginning with tax years after 1986, 

section 936 does apply to the Virgin Islands. U.S. corporations operating in American Samoa 

or Guam qualify for special tax treatment under section 936 in the same manner as U.S. 

corporations operating in Puerto Rico. Moreover, American Samoa and Guam, like Puerto Rico, 

provide exemptions from or rebates of their local possession income tax to complement the 

exemption from Federal tax under section 936. 

The first part of this Appendix describes the income tax laws of American Samoa and Guam. 

It is estimated that possessions corporations operating in Guam were subject to an effective 

Guam income tax rate of 10 percent; possessions corporations operating in American Samoa 

were generally subject to no possession income tax. The reduction in U.S. Federal tax 

provided under section 936 to all possessions corporations operating outside of Puerto Rico 

was approximately $1.5 million in tax year 1983. 

The second part of the Appendix describes the tax treatment accorded to corporations 

operating in the Virgin Islands. Under the Revised Organic Act of 1954, section 28(a)2 

, all 

"inhabitants" of the Virgin Islands satisfied their liability for U.S. tax by paying tax to 

the Virgin Islands. The Virgin Islands was required by the Naval Appropriations Act of 

19223 to administer the U.S. income tax laws as the Virgin Islands territorial income tax, 

but was allowed to rebate tax that it collected on Virgin-Islands-source income earned by 

U.S.- or V.1.-chartered corporations operating primarily in the Virgin Islands. In 1983. 

the amount of income tax rebated under the Virgin Islands tax incentive program is estimated 

to have been $8 million, of which about half was attributable to Virgin Islands subsidiaries 

of U.S. corporations. The Tax Refonn Act of 1986 continues this "mirror code" approach. 

although it repeals the V.l. inhabitant rule. 

1 Section 936 benefits also apply to the Northern Marianas Islands. Section 936 applied to the Panama Canal Zone 

until September 30. 1979. Pursuant to the Panama Canal Treati~s of 1977. the United States ceased to have 

jurisdiction over the Panama Canal Zone on October I . 1979. 

2 48 u.s.c. 1642. 

J 48 u.s.c. 1397. 

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-88-

I. American Samoa and Guam 

American Samoa and Guam, like Puerto Rico, constitute income tax jurisdictions separate 

from that of the United States. American Samoa and Guam have primary jurisdiction to tax 

U.S. corporations operating in their territories. 

In 1963, the legislature of American Samoa adopted the "Samoan Income Tax Act" which 

provides that: 

The income tax and the income tax rules in force in the United States of America and 

those which may hereafter be enacted or adopted, where not clearly inapplicable or 

incompatible with the intent of this section, are adopted by American Samoa, and shall 

be deemed to impose a separate territorial income tax, payable to the government. 

American Samoa generally applies the U.S. Internal Revenue Code as the American Samoan 

Income Tax by substituting the words "American Samoa" for "United States" where appropriate. 

The legislature of American Samoa has occasionally amended the locally applicable U.S. 

income tax laws and thus does not have a strict "mirror code." American Samoa also provides 

exemptions from tax on American Samoan source income to businesses whose investments are 

deemed to promote Samoan economic development. To qualify for tax exemption, a corporation, 

pa11nership, or sole proprietorship must employ a work force at least 75 percent of which 

consists of American Samoan residents. (A resident is any person who has continuously 

resided in American Samoa for at least five years.) Tax exemption grants generally last ten 

years and are subject to renewal. However, the period of tax exemption may terminate 

earlier if the cumulative amount of all taxes forgiven under the grant equals 200 percent of 

the business' total investment in American Samoa. 

Guam does not have the authority to adopt its own income tax system, and the income tax 

system which Congress P.rovided .for it is closely integrated with that of the United States. 

The Organic Act of 19504 required that Guam administer the income tax laws in force in the 

United States as the Guam territorial income tax, the so-called Guam "mirror" tax. The U.S. 

Internal Revenue ~ode was generally applied as the Guam territorial income tax by 

substituting "Guam" for "United States" where appropriate. Fonner section 935 of the 

Internal Revenue Code provided that individuals who were residents of Guam but · derived 

income from the United States filed a single income tax return with Guam: individuals who 

were residents of the United States but derived income from Guam filed a single return with 

the United States. The United States and Guam then reallocated taxes between their 

respective treasmies through the "cover-over" procedure in Code Section 7654. In addition. 

Code section 881 (b) provided that (under certain conditions relating to stock ownership and 

the source of the corporation ·s total income) interest. dividends. and other passive 

investment income received from U.S. sources by corporations chartered in Guam was exempt 

4 48 u.s.c. 1421i. 
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from the U.S. tax withheld at source on such gross amounts. Similarly. passive investment 

income received from Guam sources by corporations chartered in the United States was exempt 

from the Guam tax withheld at source on such gross amounts. 

Under the 1986 Tax Reform Act, Guam is granted fulJ authotity to dete1mine its own income 

tax laws, provided that (I) Guam signs an implementing agreement with the U.S. to exchange 

information and prevent tax evasion, and (2) the new system raises as much revenue as the 

mirror system. No such agreement has yet been signed. so pre-1986 law continues in effect. 

After an agreement is signed, residents of Guam receiving income from outside the possession 

in excess of minimum filing thresholds will have to file a U.S. tax return. The U.S. will 

collect tax on the non-possession income but will then transfer the money to Guam. 5 

No federal provision explicitly limits the authority of Guam to provide income tax relief 

through rebates. Under the tax incentive program of Guam, the Guam Economic Development 

Authority provides rebates of up to 100 percent of Guam income taxes to corporations that 

meet minimum investment and certain other requirements (such as increasing employment. 

replacing imports, or creating needed facilities). The rebate is generally allowed for ten 

years. 

Most possessions corporations operating in Guam in 1983 were entitled to a rebate of 75 

percent of Guam income taxes. Given the effective exemption from U.S. tax under section 

936, these corporations paid an over-all effective tax rate of about 10 percent on income 

from the active conduct of a trade or business in Guam and on QPSII (i.e., Guamanian-source 

income derived from the reinvestment of income from the Guam trade or business). Many of 

these 936 corporations also enjoyed exemption from the Guam real prope11y tax. Dividends 

paid by certain tax-exempt corporations to individual shareholders were also eligible for a 

rebate of 75 percent of the Guam shareholder level income tax. 

II. Virgin Islands 

A. Taxation of Corporations Operating in the Virgin Islands 

In 1983,_ the Virgin Islands was not treated as a possession for purposes of section 936, 

although V.I. corporations (and U.S. corporations operating in the V.l.) received benefits 

similar to those provided to 936 corporations. In the 1986 Tax Reform Act, however. the 

rules were .modified to grant the Virgin Islands treatment under section 936 identical to the 

treatment given to other possessions. 

The Naval Appropriations Act of 1922 required the Virgin Islands to administer the U.S. 

income tax laws as the Virgin Islands territorial income tax (the so-called Virgin Islands 

"mirror" tax). In 1954. Congress enacted section 28{a) of the Revised Organic Act to 

allocate taxing responsibilities and to transfer additional revenues to the Virgin Islands. 

Section 28(a) provided that 

5 Similar rules were enacted for the Commonwealth of the Northern Marianas Islands. 
- - - -- - -~ ..... 

-90-

[inhflhitonts of the Virgin Is1ands 1 sha11 Sflti~fy their income tax ohligRtion~ unclt'r the 

taxing laws of the United States by paying their tax on income from all sources both 

within and without the Virgin Islands into the Treasury of the Virgin Islands. 

In other words, Virgin Islands "inhabitants" were subject to Virgin Islands tax on their 

worldwide income and generally paid no tax to the United States, even on U.S.-source income. 

"Inhabitants" of the Virgin Islands included U.S. citizens who were resident in the Virgin 

Islands as of the last day of their taxable year, corporations chartered in the Virgin 

Islands. and certain U.S. corporations which operated primarily in the Virgin Islands. The 

1986 Tax Reform Act repealed the V. I. inhabitant rule. Instead, it provided that any bona 

fide V .I. individual resident be taxable only in the Virgin Islands. A U.S. individual who 

derives income from the V.I. files two identical returns, one with the U.S. and one with the 

V. I. , and pays a pro rata amount of tax to each jurisdiction; a special schedule is 

completed to make the pro ration. Corporations earning income in both the U.S. and the V.I. 

must file returns with each jmisdiction and may receive credit for taxes paid to the other 

jurisdiction. 

Section 934(a). added to the Internal Revenue Code in 1960~ prohibited the Virgin Islands 

from granting relief, directly or indirectly. from Virgin Islands income tax. However, an 

exception was made , under section 934(b), with respect to non-U.S.-source income of U.S. or 

Virgin Islands corporations that derived at least 80 percent of their gross income from 

Virgin Islands sources and at least 50 percent of their gross income from the active conduct 

of a trade or business in the Virgin Islands during the three-year period preceding the 

close of the taxable year. TEFRA increased the 50-percent active trade or business test to 

65 percent for taxable years beginning after December 31, 1984. The provision was phased in 

so that the required percentage of active trade or business income rose to 55 percent for 

taxable years beginning in J 983 and to 60 percent for taxable years beginning in 1984. Tilis 

provision was repealed in 1986. 

The Virgin Islands has established an industrial incentive program that provides tax 

rebates for corporations meeting the gross income tests of section 934(b) and certain 

further criteria. The principal requirements are that the corporation: 

(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 the hiring of any non· 

resident workers; and 

( 4) conform to ecological standards established by Federal or local law. 
-91-

In addition to these specific requirements. the Virgin Islands considers applications 

taking into account the following general considerations: 

( l) 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 Virgin Islands businesses. 

Corporations benefiting from the V .I. Industrial Development Program generally receive 

rebates of 75 percent or 90 percent of income taxes paid, rebates of 90 percent of customs 

duties, and up to 100 percent exemptions from the V.I. real property tax, gross receipts 

tax. and excise tax. Rebates of income tax do not. however, apply to corporate tax on 

interest income, capital gains. and certain types of rental income. The particular package 

of benefits is negotiated between the applicant and the Virgin Islands Industrial 

Development Commission. 

In general, the duration of a tax exemption grant is ten years. A firm is allowed the 

option of determining when tax benefits commence, provided they are initiated at some point 

during the first five years of business operations. An additional five years of benefits 

(or up to ten years at not more than 50 percent of the benefits) are granted to corporations 

which locate their plants in certain economically depressed areas. Moreover, any beneficiary under the Industrial Development Program may be granted a renewal of those benefits 

subject to approval of the Governor of the Virgin Islands. A corporation which was deemed 

to be an "inhabitant" of the Virgin Islands within the meaning of section 28(a) of the 

Revised Organic Act, and which qualified under Code section 934(b) and the Industrial 

Development Program for a rebate of 75 percent of income taxes, paid an average effective 

corporate income tax rate in the Virgin Islands of approximately 10 percent. 

B. Taxation of Dividends Received from Corporations Operating in the Virgin Islands 

U.S. law generally imposes a 30-percent tax on the gross amount of dividends. interest. 

and certain other passive investment income paid by U.S. persons to nonresident aliens and 

foreign corporations when that income is not effectively connected with the conduct of a 

U.S. trade or business by the foreign person. This tax is often reduced or eliminated by 

income tax treaties, but the Virgin Islands is not a pa11y to U.S. income tax treaties. The 

Government of the Virgin Islands an·d the U.S. Internal Revenue Service take the position 

that the mirror system imposes a similar 30-percent tax withheld at source on the gross 

amount of passive investment income paid from Virgin Islands sources to non-Virgin Islands 
-92-

persons. including U.S. persons.

6 A U.S. recipient of passive investment inc0me from the 

Virgin Islands can take a foreign tax credit for any such tax against its U.S. tax 

liability. but the amount of the credit is limited to the U.S. tax liability on foreignsource net income. Therefore, the 30-percent tax on V.1.-source gross passive investment 

income frequently results in such income being taxed at a higher rate than similar income 

earned by U.S. persons in the United States or foreign treaty countries. The Virgin Islands 

could not rebate this tax under section 934(b) as it existed before the Tax Reform Act of 

1986 because the tax is on the U.S. recipient and not on the V. I. corporation. 

To remove this disincentive to investment by U.S. persons in the Virgin Islands, 

legislation was enacted in January 1983 adding a new section 934A to the Internal Revenue 

Code. This section reduced from 30 percent to 10 percent the rate of Virgin Islands tax 

imposed on payments of Virgin-Islands-source passive investment income to U.S. corporations. 

citizens. and resident aliens. 7 The 1983 Act allowed the Virgin Islands to use rebates to 

fm1her reduce or eliminate this 10-percent rate. However. the 1983 Act continued the 30-

percent rate for dividends paid to U.S. persons out of earnings and profits accumulated 

during taxable years beginning before January 12. 1983. The Act treated dividends as coming 

first out of earnings and profits accumulated during taxable years beginning before January 

12. 1983. so that the 10 percent tax rate on dividends received by U.S. persons applied only 

after a corporation operating in the Virgin Islands has distributed all pre-1983 earnings 

and profits. The Tax Reform Act of 1986 repealed Code section 934A and replaced it with a 

new Code section 934(b)(l), which allows the Virgin Islands to reduce V.l. tax on any income 

which is from V.I. sources or is effectively connected with the conduct of a trade or 

business in the Virgin Islands. 

Dividends received from a U.S. subsidiary operating in the Virgin Islands are eligible 

for the dividends-received deduction under section 243 of the Code. Howeve ·, for the years 

prior to 1987. the United States generally did not allow a U.S. parent to take a dividendsreceived deduction for dividends paid by a subsidiary incorporated in the Virgin Islands. 8 

6 The U.S. Court of Appeals for the Third Circuit cast doubt on this interpretation of the mirror system. Viteo v. 

Government of the Virgin Islands, 560 F. 2nd 180 (3rd Cir. 1977). cert. denied, 435 U.S. 180 ( 1978). 

However, the Report of the Committee on Ways and Means on H.R. 7093 (Public Law 97-455), an Act to reduce 

the rate of the Virgin Islands tax from 30 percent to 10 percent on payments to U.S. persons, states that. 

"The bill makes clear the Virgin Islands right both to impose the tax and to collect it by· requiring 

withholding." H.R. Rep No. 833. 97th Congress 2nd Sess. 4 (1982). 

1 · Public Law 97-455, section l (1983). 

8 This follows from the treatment of Virgin-Islands-chartered corporations as foreign corporations for purposes of 

U.S. income taxation. The general rule with respect to foreign corporations for pre-1987 years was that a U.S. 

corporate shareholder is allowed the dividends-received deduction only if 50 percent or more of the foreign 

corporation's income has been derived from a U.S. trade or business for the thirty-six months (or lesser period 

that the corporation has been in existence) ending with the close of the taxable year in which the dividends are 

paid. The deduction is allowed only to the extent of the corporation's effectively connected income. A 
-93-

Thus. even though the profits of a 934(b) Virgin Islands subsidiary might ha"e heen 75-

percent or 90-percent tax-free in the Virgin Islands, the profits were subject to the normal 

U.S. corporate rate of income tax once they were repatriated. 

In 1980, the Internal Revenue Service ruled that a U.S.-chartered corporation which 

satisfied the 80-50 gross income tests under former section 934(b), conducted all 

significant business operations in the Virgin Islands, held all shareholder meetings in the 

Virgin Islands, and all of whose officers were Virgin Islands residents. constituted an 

"inhabitant" of the Virgin Islands. 9 The ruling did not make clear whether all these 

conditions must be satisfied to qualify as an "inhabitant" of the Virgin Islands. and most 

U.S. investors in the Virgin Islands continued to operate through Virgin lslands-cha11ered 

corporations. Therefore. their income from the Virgin Islands became subject to U.S. tax at 

the time it was repatriated in the form of dividends, and a foreign tax credit was allowed 

(subject to the general foreign tax credit limitation) for taxes paid to the Virgin Islands. 

The 1986 Tax Reform Act exempts U.S. -source fixed or determinable, annual or periodic income 

from U.S. withholding tax if 65 percent of the V.I. corporation's income is effectively 

connected with a trade or business in the U.S. or in a possession. and the other 

requirements of section 881 (b) are met. 

A few U.S. corporations operating in the Virgin Islands took the position that. as 

"inhabitants" of the V.I.. they satisfied their U.S. tax obligation by paying taxes to the 

V. I.. but that they were taxable by the V. I. only on V. 1.-source and V. 1.-effectivel y 

connected income. U .S.-source income, these taxpayers contended. was not taxable in either 

the U.S. or the V.I. A 1987 decision by the U.S. Court of Appeals for the 3d Circuit 

(Danbury, Inc. v. Olive, 820 R.2d 618 (3d. Cir.) ce11. denied, 108 S.ct. 453 (1987)) made 

clear that these taxpayers could not escape taxation on their non-V. I. income. 

C. Allocation of Income Attributable to Intangibles 

Under former section 934(e) (repealed by the 1986 Tax Reform Act), TEFRA's rules on the 

allocation of income from intangibles under the cost-sharing or the profit-split method 

applied to U.S. corporations described in former section 934(b0 in a manner similar to those 

compaines covered under section 936(h). The provisions were generally effective for taxable 

years beginnfog after December 31, 1982, and before January I, 1987. As indicated above. 

section 936 itself has been expanded to cover qualifying U.S . . companies doing business in 

the Virgin Islands for taxable years beg~nning after December 31, 1986. 

corporation which met the so-called "80-65 gross income tests" required to be eligible for V .I. tax relief would 

not qualify for the deduction even with respect to dividends attributable to U.S.-source income (Code section 

245(a)). 

9 Revenue Ruling 80-40. 1980-2 C.B. 175. 
- - --- ~------- ---- - -- -- - ~ 

-94-

D Charart~ristks of Corporations, Partnerships, and Sole Prorrietor!(;hips Eligible for 

Virgin Islands Tax Rebates 

Table A- 1 presents data on asset and income items associated with former section 934(b) 

companies for I 983. by industry. The data were obtained from income tax returns filed in 

the Virgin Islands. The forty-seven companies were nearly evenly split between manufac-

_ tuiing (tw_oofy-two) and services (twenty-five). Some of the more dominant industries were 

hotels. with 19 percent of the companies and 6.4 percent of the assets; chemicals, with 8.5 

percent of the companies and 5.5 percent of the assets; and watches, with 12.8 percent of 

the companies and 3.6 percent of the assets. Jewelry and broadcasting were also important 

industries. ·· 

Total assets held by the 47 companies were $298 million. Nearly all of the assets were 

held by V. I. subsidiaries of U.S. corporations. Net plant and equipment of $99 million 

represented 33 percent of total assets, or three times the analogous share for 936 

companies. 

Business receipts provided 87 percent of the gross receipts of 934(b) entities. 

Info1mation on non-government interest and other investment income of 934(b) corporations is 

not available. but the high share of business receipts in total receipts suggests that 

passive investment income represents a relatively insignificant share of the income of 

934(b) entities. As noted above, the Virgin Islands Industrial Development Program, unlike 

the Pue110 Rican Industrial Incentive Acts. does not provide relief from tax on interest and 

ce11ain other kinds of passive investment income. 

Taxable income equals the difference between total gross income and total (current) 

deductions, less net operating loss carryovers and certain special deductions for dividends 

received. The combined taxable income of the forty-seven entities shown in the table 

amounted to approximately $36 million; the nine hotels reported an aggregate loss of nearly 

$2 million. 

Virgin Islands income tax rebates due, which represented in most cases 75 or 90 percent 

of income taxes paid, were estimated to be about $1.8 million. This represents about 5 

percent of aggregate taxable income. 
TABLE A-1 

934(B) CORPORATIONS IN THE VIRGIN ISLANDS - SELECTED BALANCE SHEET AND INCOME 

STATEMENT ITEMS AND TAX BENEFITS BY INDUSTRY, 1983 

($ thousand) 

r 0 er 

industries Chemicals Watches manufacturin Hotels services 

Number of Corporations 47 4 6 12 9 16 

Total Assets 297,601 16,470 10,855 135,237 19,055 . 115,983 

Inventories 50,310 693 2,567 44,578 386 2,086 

Depreciable assets 136,708 4,790 1,294 9,023 18,129 103,472 

Accumulated depreciation 37,669 376 606 3,597 4,063 29,027 

Net depreciable assets 99,039 4,414 688 5,427 14,066 74,445 

Total Receipts 308,153 15,863 14,572 169,277 17,829 90,612 I 

\0 

Business receipts 269,024 14,438 13,498 168,264 16,497 56,326 Vt 

I 

All other receipts 39,129 1,425 1,074 1,013 1,332 34,285 

Total Deductions 272,454 14,829 13,998 140,617 19,639 83,370 

Cost of sal~s and 

operations 156,966 9,426 11,822 89,173 6,920 39,625 

All other deductions 115,487 5,403 2,176 51,444 12,719 43,746 

Taxable income 35,699 1,034 574 28,660 -1,810 7,241 

V.I. Rebates 1,824 44 246 147 294 1,093 

Department of the Treasury 

Office of Tax Analysis 
Appendix B 

POSSESSIONS CORPORATIONS IN TAX YEAR 1982 

This appendix pr~sents data on the assets, income, and tax benefits of all possessions 

corporations in tax year 1982. which includes accounting periods ending between July 1, 

1982. and June 30, 1983. Tax year 1982 corresponds closely to the calendar year because 

most possessions corporations had calendar-year accounting periods. Tables B-1 through B-3 

below are similar to Tables 4-1, 4-4, and 4-6, in the text. Both sets of tables include all 

of the returns filed for the given tax year. The 1982 tables in this appendix update the 

tables in the Fifth Report because they include 1982 tax returns filed after the report was 

written. The 1983 tables include all 1983 returns, so no appendix B will be necessary for 

the Seventh Repo11. 

In tax year 1982, the estimated tax benefits provided under section 936 were $1.8 

billion. up from $1. 7 billion for tax year 1981 and $1.3 billion for tax year 1980. The net 

income of possessions corporations in manufacturing rose 6 percent between 1981 and 1982, 

compared to a 30 percent increase from 1980 to 1981. The increase in 1982 was particularly 

strong in the chemical industry, where profits rose 19 percent. The profits of the 

pharmaceutical industry rose 34 percent in this period.1 

I. Assets and Income in 1982 

A. Assets 

Table B-1 shows that in 1982 the book value of the total assets of possessions 

corporations was $2 l. 6 bill ion, of which $15. 8 billion were held in manufacturing 

industries. Net plant and equipment of 936 manufacturing firms amounted to $1. 9 billion in 

1982. 

B. Retained Earnings 

In 1982. possessions companies reported $13.8 billion of retained earnings on their 

balance sheets. with 96 percent held by manufacturing companies. Nearly half. or $6. l 

bil1ion. was held by pharmaceuticals. The electrical and electronics industries held $3.0 

billion in retained earnings. For all manufacturing possessions corporations, retained 

earnings represented 84 percent of total liabilities and stockholders' equity. The 

comparable figure for manufacturing corporations operating in the U.S. was 36 percent.

2 

1 For data on possessions corporations in 1980 and 1981. see Table 4-9. 

2 See the Quarterly Financial Reports, 1983 and 1984. put out by the Federal Trade Commission. 

-97-
Number of corporations 

Total Assets 

Cash 

Accounts receivable 

Inventories 

U.S. Government obligations 

Other current assets 

Mortgage and real estate loans 

Other investments 

Depreciable assets 

Less: Accumulated depreciation 

Net depreciable assets 

Other assets 

TABLE B-1 

SELECTED BALANCE SHEET INFORMATION BY INDUSTRY, 1982 

($ thousand) 

Manufacturing industries 

All 

industries 

Manufacturing I ~~~:r:d I Textile mill I I I Chemicals 

total products products Apparel Paper I Total I Pharmaceuticals l All other 

620 

21,589,862 

3,144,786 

4,270,876 

1,690,181 

525,744 

1,262,897 

1,960,467 

5,146,624 

4,394,843 

1,533,243 

2,861,600 

726,688 

502 

15,802,904 

2,620,589 

3,127,016 

1,525,979 

448,731 

1,214,033 

147,810 

4,417,514 

2,920,778 

1,101,419 

1,819,360 

481,874 

23 

982,300 

274,392 

265,951 

153,768 

0 

14,731 

0 

64,766 

225,332 

75,694 

149,638 

59,054 

8 

101,035 

13,539 

16,419 

5,237 

858 

52 

0 

35,168 

5,755 

3,914 

1,841 

27,921 

76 9 95 

473,407 40,467 8,080,295 

77,245 

165,212 

55,408 

3,303 

11,267 

3,226 

117,148 

47,601 

22,528 

25,074 

15,525 

2,705 

8,064 

3,050 

0 

241 

0 

23,804 

3,806 

1,381 

2,425 

178 

934,317 

1,597,957 

537,833 

318,401 

478,879 

38,468 

2,907,696 

1,642,069 

607,449 

1,034,620 

232,126 

59 

7 ,078, 714 

883,749 

1,185,122 

418,271 

257,765 

470,100 

38,468 

28,337,366 

1,069,769 

282,398 

787,372 

200,503 

36 

1,001,581 

50,568 

412,835 

119,561 

60,636 

8, 779 

0 

70,330 

572,299 

325,051 

247,248 

31,623 

Total Liabilities and Stockholders' Equity 

Accounts payable 

Notes payable in less than one year 

Other current liabilities 

Notes payable in one year or more 

Other liabilities 

capital stock 

Retained earnings, total 

Appropriated 

Unappropriated 

1,513,880 

316,242 

2,711,460 

836,303 

538,687 

1,887,994 

13,785,296 

106,624 

13 ,678 ,672 

722,088 

161,819 

375,751 

199,606 

226,611 

9!0,068 

13,206,962 

39,640 

13,167,322 

85,788 

7,284 

54,944 

17,000 

19,740 

41,657 

755,887 

13,605 

742,282 

693 

43 

1,192 

64 

0 

640 

98,402 

0 

98,402 

42,859 

3,912 

14,187 

5,958 

1,642 

23,823 

381,027 

0 

381,027 

2,819 

459 

906 

0 

37 

1,054 

35,191 

0 

35,191 

224,024 

100,984 

173,205 

145,026 

137,381 

527,238 

6,772,437 

2,900 

6,769,537 

180,535 

95,232 

164,928 

138, 771 

119,039 

317 ,111 

6,063,099 

2,266 

6,060,833 

43,488 

5,752 

8,278 

6,255 

18,342 

210 ,127 

709,338 

635 

708,703 

I 

\0 

00 

I 
TABLE B-1 - continued 

Manufacturing industries - continued 

Rubber and Leather and Stone, clay, Machinery, Electrical and Instruments 

plastic leather and Fabricated except electronic and related All other 

products roducts glass products metal products electrical equipment roducts manufacturing 

Number of corporations 11 18 6 29 11 119 42 55 

Total Assets 78,258 129,279 21,275 289,185 292,214 3,378,529 810,048 1,126,611 

Cash 5,321 30,827 4,434 25,548 18,700 920,641 164,320 148,599 

Accounts receivable 27,445 29,445 2,415 66,702 52,812 482,436 183,668 228,480 

Inventories 9,435 23,706 2,624 36,766 29,390 366,381 69,311 233,070 

U.S. Government obligations 0 18,441 0 324 23,983 55,267 25,282 2,873 

Other current assets 158 716 352 26,032 55,807 523,225 10,078 92,497 

Mortgage and real estate loans 0 333 0 0 1,261 101,002 0 3,521 

Other investments 8,422 17,443 10,254 35,958 85,548 649,654 240,439 221,215 

Depreciable assets 33,568 12,676 1,011 97,594 24,202 416,488 128,176 282,499 

Less: Accumulated depreciation 8,245 4,595 559 28,873 7,927 173,006 35,165 132,082 

Net depreciable assets 25,324 8,081 452 68,721 16,275 243,482 93,011 150,416 

Other assets 2,144 289 744 29,135 8,437 36,441 23,939 45,940 

I 

Total Liabilities and Stockholders' EquitX \0 

\0 

I 

Accounts payable 3,934 9,314 259 19 ,148 23,438 141, 721 55,190 112,901 

Notes payable in less than 1 year 788 1,354 312 6,641 1,001 27,975 1,427 9,640 

Other current liabilities 1,769 3,098 339 4,517 4,550 83,371 14,640 19,032 

Notes payable in 1 year or more 0 4,499 66 4,815 2 14,345 1,233 6,598 

Other liabilities 1,567 5,503 1 1,116 4,576 39 ,133 3,880 12,034 

Capital stock 8,747 -3,593 3,562 40,781 7,427 110,816 28,180 119,735 

Retained earnings, total 61,453 109,104 16,736 212,165 251,220 2,961,168 705,499 846,672 

Appropriated 1, 709 3,589 0 0 0 8,404 8,870 562 

Unappropriated 59,744 105,515 16,736 212,165 251,220 2,952,764 696,629 846,110 
TABLE B-1 - continued 

Nonmanufacturing industries 

Nonmanu- I I 

Transportation, 

I I Retail I 

Finance, I Other servicei:; 

facturing coJlllllWlications, insurance, and industries 

total Construction and utilities Wholesale trade trade real estate not reparted 

NUmber of corporations 118 8 6 28 12 28 36 

Total Assets 5,786,958 36,100 910,941 645,993 220,362 3,886,942 86,621 

Cash 524,197 1,499 42,829 187,002 16,500 270,483 5,884 

Accounts receivable 1,143,861 5,081 52,250 210,827 45,985 795,725 33,993 

Inventories 164,202 0 15,841 99,381 43,885 630 4,465 

U.S. Government obligations 77,012 0 0 448 0 76,548 16 

Other current assets 48,864 2,799 3,928 1,429 18,311 21,007 1,390 

Mortgage and real estate loans 1,812,657 32 0 0 0 1,812,624 0 

Other investments 729,111 3,469 13,175 15,791 23,640 665,145 7,889 

Depreciable assets 1,474,065 8,302 1,049,463 205,998 99,769 75,566 34,967 

Less: Accumulated depreciation 431,824 3,291 276,854 84,583 41,595 13,862 11,638 

Net depreciable assets 1,042,241 5,011 772,608 121,415 58,174 61,704 23,329 

Other assets 244,814 18,208 10,310 9,699 13,867 183,075 9,655 I 

Total Liabilities and Stockholders' E~ity -

0 

0 

Accounts payable 791,792 2,524 19,871 52,872 49,385 650,994 16,146 I 

Notes payable in less than 1 year 154,422 16,847 10,892 3,538 8,649 111,597 2,900 

Other current liabilities 2,335,709 5,710 42,362 4,061 11,660 2,265,012 6,904 

Notes payable in 1 year or more 636,697 5,537 111,537 9,377 43,532 462,310 4,404 

Other liabilities 312,076 281 54 4,942 3,105 297,272 6,422 

Capital stock 977,926 329 714,789 133,260 24,375 81,859 23,314 

Retained earnings, total 578,335 4,872 114,436 437,943 79,656 17,898 26,530 

Appropriated 66,984 0 10,159 3 8,603 48,219 0 

Unappropriated 511,351 4,872 1,276 437,940 71,053 -30,321 26,530 

Department of the Treasury 

Office of Tax Analysis 
-101-

C. Total Receipts 

Table B-2 shows that the total receipts of manufacturing possessions corporations were 

$15 billion in 1982. Ninety-two percent of total receipts was attributable to business 

receipts, and the remainder was attributable ptimarily to interest, including QPSII. 

Interest on Puerto Rican and state and local government securities is excluded from gross 

income for federal tax purposes and therefore is not included in the total receipts shown in 

Table B-2. 

The pharmaceutical industry accounted for 35 percent of the business receipts of all 

possessions manufacturing firms. After pharmaceuticals, the industries with the largest 

amount of business receipts were electrical and electronic equipment (with 20 percent), and 

food products (with 8 percent). 

D. Net Income per Tax Return 

Net income per return amounted to $4.3 billion for all possessions corporations in 

manufacturing. The industries with the most net income were pharmaceuticals, with 51 

percent of the total, and electrical and electronic equipment, with 21 percent of the total. 

E. Reduction in U.S. Tax Liability 

Table B-2 shows that U.S. tax liabilities were reduced by $1, 773 million in tax year 1982 

by the possessions corporation system. The pharmaceutical industry obtained tax benefits of 

$906 million. and the electrical and electronic equipment industry obtained tax benefits of 

$369 million. Other industries which received substantial tax benefits were instruments 

($110 million) and food products ($93 million). 

F. Distributions 

The final line of Table B-2 shows that manufacturing possessions corporations reported 

$2.563 million of distributions. These disttibutions represented 59 percent of net income. 

The pharmaceutical industry was responsible for 58 percent of the. distributions. The 

percentage of profits distributed increased substantially from 1981 to 1982, going from 41 

percent to 59 percent. 

II. Payroll and Employment in 1982 

Table B-3 provides an industry comparison of 936 tax benefits per employee and as a 

percent of industry compensation. Table B-3 is based on all possessions firms in the 

manufacturing sector for which 1982 employment and payroll data could be obtained from the 

companies· federal unemployment insurance tax returns. The 378 corporations included in the 

table represent 75 percent of the manufacturing corporations included in Tables B-1 and B-2. 
TABLE B-2 

SELECTED INCOME STATEMENT INFORMATION AND TAX BENEFITS BY INDUSTRY, 1982 

($ thousand) 

All Manufac- Food and kin- Textile Cllemicals 

industries turin total dred products mill products Total Pharmaceuticals All other 

Number of corporations 620 502 23 8 76 9 95 59 36 

Total. receipts 14,953,719 12,246,742 983,765 63,685 501,868 37,748 5,173,049 4,333,070 839,979 

Business receipts 13,722,598 11,418,410 937,218 62,119 459,284 35,419 4,763,627 3,941,610 822,017 

Nongovernment interest 992,526 677,949 34,519 1,480 17,184 2,281 349,159 332,458 16,701 

other receipts 238,597 150,385 12,028 86 25,400 48 60,264 59,003 1,261 

Total deductions 10,410,629 7,911,003 752,857 53,089 400,142 25,241 2,768,182 2,104,681 663,501 

I 

Cost of sales 7,245,183 5,712,013 508,925 47,577 341,912 21,210 1,554,839 1,034,459 520,380 -

0 

Depreciation 251,415 157,889 10,363 433 3,112 397 83,319 58,929 24,390 N 

I 

All other deductions 2,914,033 2,041,102 233,569 5,078 55,118 3,633 1,130,024 1,011,293 118,731 

Estimated net income per return 4,543,091 4,335,740 230,909 10,596 101,725 12,507 2,404,867 2,228,390 176,477 

Estimated net income per books 4,360,146 4,151,927 225,914 8,295 97,746 12,407 2,317,335 2,146,411 170,924 

Reduction in U.S. tax liability . 1, 772,671 1, 772,671 92,739 4,122 41,415 884 973,752 905,996 67,756 

Distributions 2,676,377 2,563,465 113,780 210 46,453 1,000 1,615,530 1,475,441 140,089 
Number of corporations 

Total receipts 

Business receipts 

Nongovernment interest 

Other receipts 

Total deductions 

Cost of sales 

Depreciation 

All other deductions 

Estimated net income per return 

Estimated net income per books 

Reduction in U.S. tax liability 

Distributions 

Rubber and I 

plastic 

products 

11 

89,051 

87,742 

874 

435 

64,597 

48,739 

1,514 

14,345 

24,454 

25,735 

10,370 

14,245 

Leather and I 

leather 

products 

18 

168,687 

164,780 

3,609 

299 

150,147 

129,868 

1,290 

18,989 

18,541 

19,262 

13,598 

2,016 

TABLE B-2 - continued 

Manufacturing industries - continued 

Stone, clay, I Fabricated I Machinery, I Electrical and I 

and glass metal except electronic 

products products electrical eauipment 

6 

13,296 

11,213 

252 

1,830 

10,001 

7,670 

68 

2,263 

3,295 

3,406 

1,309 

357 

29 

208,747 

199,501 

7,437 

1,810 

162,450 

137 ,495 

5,512 

19,443 

46,297 

48,411 

19,258 

32,386 

11 

224,667 

210,046 

13,682 

939 

154,094 

135,126 

2,799 

16,169 

70,573 

67,870 

29,104 

27,121 

119 

2,422,933 

2,238,499 

177,599 

6,836 

1,527,296 

1,252,739 

25,682 

248,876 

895,638 

821,032 

368,904 

460,107 

Instruments I 

and related 

products 

42 

624,067 

579,930 

35,732 

8,405 

367,834 

270,463 

8,642 

88, 729 

256,233 

254,275 

109,867 

93,843 

All other 

manufacturing 

55 

1,735,178 

1,669,033 

34,141 

32,005 

1,475,072 

1,255,450 

14,758 

204,865 

260,106 

250,238 

102,351 

156,416 

0 

w 

I 

1 
TABLE B-2 - continued 

Non-manufacturin industries 

Nonmanu- Transportation, Finance, Other services 

facturing communications, insurance, and industries 

total Construction and utilities Wholesale trade Retail trade real estate not re rted 

Number of corporations 118 8 6 28 12 28 36 

Total Receipts 2,706,977 40,881 341,068 1,182,766 659,747 350,057 132,458 

Business receipts 2,304,188 36,460 328,936 1,155,680 635,705 31, 722 115,684 

Nongoverrunent interest 314,577 680 2,447 24,132 179 286,218 921 

Other receipts 88,212 3,740 9,685 2,955 23,862 32,118 15,852 

Total Deductions 2,499,627 36,402 267,769 1,041,849 655,063 372,935 125,609 

Cost of sales 1,533,170 29,239 2,795 977,351 472,664 5,866 45,255 I 

Depreciation 93,526 1,271 71,169 7,384 7,507 4,003 2,192 

All other deductions 872,931 5,892 193,805 57,114 174,892 363,066 78,162 -

0 

~ 

I 

Estimated net income per return 207,351 4,479 73,299 140,918 4,684 -22,878 6,848 

Estimated net income per books 208,219 3,317 73,244 134,332 6,167 -17,835 8,994 

Reduction in U.S. tax liability 0 0 0 0 0 0 0 

Distributions 112 , 912 7,708 75,392 22,678 1,528 0 5,605 

Department of the Treasury 

Off ice of Tax Analysis 
-105-

Tahle B-3 shows that the federal tax henefits per employee in Puerto Rko for all 

manufacturing corporations are estimated to have averaged $20,699. Tax benefits per 

employee. and tax benefits as a percentage of total employee compensation, varied 

substantially from industry to industry. In the pharmaceutical industry, the average 

federal tax benefits amounted to $69, 751 per employee, or more than triple the average 

compensation of the comparatively well-paid Puerto Rican pharmaceutical employee. In the 

electtical and electronics industry, the average tax benefits amounted to $14,879 per 

employee, or 108 percent of average compensation. The industries where average tax benefits 

per employee were lowest were textiles and apparel. The 63 apparel firms included in Table 

B-3 provided 17 percent of the total employment and received only 2 percent of the tax 

benefits. 
TABLE B-3 

mTAX BENEFITS, EMPLOYMENT, AND COMPENSATION OF EMPLOYEES BY INDUSTRY, 1982 

Qualified Estimated nUJlber of Average Tax benefits 

possession Tax benefits emplovees employee Tax benefits as a percent 

Number of net inco11e Amount I Percentage 

Number I Percentage compensation per employee of employee 

con><> rations ($ thousand)• ($ thousand) of total of total ($) ($) Compensation 

All manufacturing industries 378 4,778,482 1,772,671 100.0 85,640 100.0 13,959b 20,699b 148.3b 

Food and kindred products 15 256,561 97,739 5.5 5,807 6.7 15,050 16,830 111.8 

Textile mill products 5 9,298 4,122 * 1,385 1.6 9,094 2,976 32.7 

Apparel 63 106,901 41,415 2.3 16,213 18.9 2,554 9,075 28.1 

Men's and boys ' 10 19,995 8,444 * 4,082 4.8 9,517 2,069 21. 7 

Women's and children's 31 58,858 23,250 1.3 7,623 8.9 8,914 3,050 34.2 

H_ats, caps, etc. 8 6,087 2,346 * 1,041 1.2 8,937 2,254 25.2 

All other 14 21,961 7,375 * 3,559 4.2 8,950 2,073 23.2 

Chemicals 71 2,657,846 973,752 54.9 15,406 18.0 20,491 63,205 308.5 

Industrial chemicals 8 99,210 36,651 2.1 1,698 2.0 26,446 21,586 81.6 

Pharmaceuticals 43 2,470,225 905,996 51.1 12,989 15.2 20,077 69,751 347.4 

Soaps, cleaners, etc. 10 56,179 18,400 1.0 572 0.7 15,080 32,185 213.4 

All other 10 32,231 12,705 0.7 653 0.8 15,654 19,467 124.4 

Rubber and plastic products 10 25,573 10,370 0.6 1,574 1.8 11,900 6,589 55.4 

Leather and leather products 15 22,387 13,598 0.8 3,767 4.4 9,507 3,610 38.0 

Footwear 10 18,287 12,321 0.7 3,420 4.0 9,465 3,603 38.1 

All other 5 4,100 1,277 323 * 9,836 3,954 40.2 0 

Stone, clay, and glass 4 3,226 1,309 133 * 16,212 9,839 60.7 CJ\ 

Fabricated metal products 22 53,294 19,258 1.1 2,233 2.6 15,323 8,623 56.3 I 

Metal cans and containers 6 20,397 7,312 * 1,003 1.2 17,668 7,287 41.2 

All other 16 32,897 11,946 0.7 1,071 1.3 13,979 11,159 79.8 

Machinery, except electrical 8 78,911 29,104 1.6 1,310 1.5 15,917 22,220 139.6 

Electrical and electronic 

equipment 95 1,002,358 368,904 20.8 24,794 29.0 13, 725 14,879 108.4 

Radio, TV, communication 10 90,487 35,195 2.0 3,135 3.7 12,571 11,228 89.3 

Electronic components 27 325, 717 134,337 7.6 9,022 10.5 14,473 14,889 102.9 

All other 58 586,153 199,372 11.2 12,452 14.5 16,011 13 ,534 118.3 

Transportation equipment 5 10,285 4,048 * 594 0.7 11,220 6,815 60.7 

Instruments and related 

products 32 287,039 109,867 6.2 7,057 8.2 13,747 15,568 113.2 

Scientific instruments 10 57,520 19,899 1.1 1,187 1.4 11,974 16,764 140.0 

All other 22 229,518 89,968 5.1 5,302 6.2 13,978 16,970 121.4 

All other 111anufacturing c 33 264,804 99,187 5.6 4,601 5.4 15,464 21,559 139.4 

Department of the Treasury 

Office of Tax Analysis 

* Less than 0.5% 

a Equals net income from the active conduct of a trade or business in a possession plus net qualified possession source investment income. 

b Compensation and number of employees were weighted, by industry, by the ratio of costs of goods sold for the entire sample to cost of goods sold 

for the sample with employment data. 

c Includes manufacturing industries in which data were available for fewer than 3 corporations. 
J. Coverage 

Appendix C 

SOURCES AND LIMITATIONS OF THE DATA 

ON POSSESSIONS CORPORATIONS 

The data in Chapter 4 on possessions corporations for tax year 1983 and the data in 

Appendix B for tax year 1982 include all corporations that fi1ed possessions corporation 

returns within twelve months of the end of the tax year. Figures for all years prior to 

198 I (e.g .. those in Table 4-7) have been revised to include corporations which filed as 

possessions corporations within twelve months of the end of the tax year. The data in 

Tables 4-9 and 4-1 I are based on all corporations that either excluded income under section 

93 I in one or more of the years J 973. 1974, 1975. and 1976, or made an election under 

section 936. 

II. Income Statement and Balance Sheet Data 

Income statement and balance sheet data for 1977-1983. and some income data for 1976. are 

from Fo1m J 120, "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 1973-1976 was Form 5712. "Election to be Treated as 

a Possessions Corporation under Section 936." If the corporation filing Form 5712 (or any 

other member of its controlled group) excluded income under section 931 for any taxable year 

beginning in 1973 , 1974, or 1975, the net income per books of that corporation for each year 

was reported on the form filed for 1976. An additional source of income and tax data for 

1973-1975 was income tax returns (Form 480.20) filed with the Puerto Rican government. 

III. Employment and Payroll Data 

The employment and payroll data for all years were taken from Form 940, "Employer's 

Annual Federal Unemployment Tax Return." These returns are filed on a calendar year basis. 

For companies with a non-calendar year accounting period. the Form 940 data were associated 

with income data for the accounting period most nearly corresponding to the calendar year. 

For example. the calendar year 1983 Form 940 data were associated with taxable years ending 

between July 1, 1983 and June 30, 1984. 

The number of employees was computed by dividing total taxable wages (line 5. Form 940) 

by $7 ,000,1 the maximum amount per employee subject to unemployment tax. This procedure 

gives an estimate of the number of full-time equivalent employees dming the year. rather 

1 For 1973-1977, the corresponding amount was $4.200, and for 1978 to 1982 , the amount was $6.000. 

-107-
-108-

than the actua1 numher of persons emp1oyed at any particular time during the year. If the 

corporation paid its workers less than $7 ,000, the number of employees could be understated. 

(The minimum wage in several industries was sufficiently low in the 1970s that this could 

have occurred.) On the other hand, because the $7 ,000 ceiling is tied to individual 

employees, the procedure could over-estimate employment for a company with relatively high 

wages and part-time employees or a high labor turnover rate. Secondary data from Form 940 

and other sources suggest that the method used here provides reasonably accurate estimates 

of full-time equivalent employment. 

Some corporations did not report an amount for total remuneration or reported the same 

amount as for wages subject to unemployment tax. In the latter case, the firm's reporting 

w.as assumed to be correct. For the few 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 1. Form 940) by a 

factor representing the ratio of total compensation to total wages and salaries for U.S. 

manufacturing industries. The value of this factor was 123.2 percent in I 982 and 123.5 

percent in 1983. It is computed from Tables 6.4B and 6.5B of the Survey of Current 

Business, U.S. Department of Commerce, Bureau of Economic Analysis, July 1986. Total 

compensation exceeds wages and salaries by the amount of employer contributions to social 

security. private pensions, and health insurance. and by other fringe benefits. 

Employment and payroll data were available for only 378 of the 527 possessions 

corporations in manufacturing. The information from that sample was weighted up to 

represent the full group. For firms with cost-of-goods-sold data. it was assumed that the 

relationship between employment and cost of goods sold for the employment sample would also 

hold for the larger sample within each industry group. If cost-of-goods-sold data were 

missing. a similar assumption was made for the relationship between employment and assets 

within each industry group. Although the cost of goods sold is more directly related to 

employment because wages are a large part of costs. many of the profit-split firms were 

missing detailed income statement data. Assets are indirectly related to employment. and 

therefore were used for an alternative relationship where cost-of-goods-sold data were 

missing. 
Appemlix D 

TAX FORMS FROM WHICH DATA INCLUDED 

IN THIS REPORT WERE OBTAINED 

-109-
1120 U.S. Corporation Income Tax Return OMB No. 1545-0123 

Form For calendar year 1983 or other tax year beginning _____________ , 1983, ending _____________ , 19 _____ 11®83 Oepertment of the Treasury 

Internal Revenue Service • For Paperwork Reduction Act Notice, see pa1e 1 of the Instructions. 

Check if a- use Name D. Emplo~r lffntlflClltlon number 

A. Consolidated return 0 11$ 

l1btl. 

L Personal Holdirc eo. D Othtr· Number and street E; Date incorporated 

C. Business Code No. (See wise 

pace 9 of Instructions) plust City or town, State, and ZIP code f. Total assets (see Specific Instructions) print 

orhDI. $ 

C. Check box if there has been a change in address from the previous year . . .,. I I 

1 (a) Grass receipts or sales$_ ________________ (b) less returns and allowances$ ________________ Balance.,. l(c) 

2 Cost of goods sold (Schedule A) and/or operations (attach schedule) . 2 

3 Gross profit (subtract line 2 from line l(c)) 3 

• 4 Dividends (Schedule C) 4 J 5 Interest 5 

6 Gross rents 6 

~ 7 Gross royalties 7 

c:J 8 Capital gain net income (attach separate Schedule D) 8 

9 Net gain or (loss) from Form 4797, line 14(a), Part II (attach Form 4797) 9 

10 Other income (see instructions-attach schedule). 10 

11 TOTAL income-Add lines 3 through 10 and enter here ... 11 

12 Compensation of officers (Schedule E) 12 

13 (a) Sllaries and wa1es $ _____________________ Jb) Less jobs credit$ ___________ • ________ ._Balance .,. 13(c) 

14 Repairs (see instructions). 14 

15 Bad debts (Schedule F if reserve method is used) 15 

16 Rents 16 

17 Taxes 17 

18 Interest 18 

19 Contributions (not over 1096 of line 30 adjusted per instructions) 19 

I 20 Depreciation (attach Form 4562) .! I 20 I ~ 

21 Less depreciation claimed in Schedule A and elsewhere on return . l21(a~ ( ) 21(bJ 'ti 

:I 22 Depletion . 22 J 23 Advertising 23 

24 Pension, profit-sharing, etc. plans (see instructions) 24 

25 Employee benefit programs (see instructions) 25 

26 Other deductions (attach schedule) 26 

27 TOTAL deductions-Add lines 12 through 26 and enter here . ... 27 

28 Taxable income before net operating loss deduction and special deductions (subtract line 27 from line 11) 28 

29 Leu: (1) Net operating loss deduction (see instructions-attach schedule) 129(1)1 ~ 

(b) Special deductions (Schedule C) l29(b 29 

30 Taxable income (subtract line 29 from line 28) . 30-

31 TOTAL TAX (Schedule J). 31 

32 Credits: (a) Overpayment from 1982 a'lowed as a credit. 

(b) 1983 estimated tax payments 

(c) Less refund of 1983 estimated tax applied for on Form 4466 ( ) ~ 

(d) Tax deposited with Form 7004 . ~ 

s (•)Credit from regulated investment companies (attach Form 2439). ~ 

(f) Federal tax on special fuels and oils (attach Form 4136). •"\ 32 

33 TAX DUE (subtract line 32 from line 31-lf line 32 is greater than line 31, skip line 33 and go to 

line 34). See instruction C3 for depositary method of payment . . . . . . . . . . . 33 

(Chee~.,. O ifForm 2220 is attached. See ioistruction 0.) .,. $ -------------- _______ !__ ___ ~ 

34 OVERPAYMENT (subtract line 31 from line 32) . . . . . . . . . . . . . . . . 34 

35 Enter amount of line 34 you want: Crtdittd to 1984 estim1ttd t11 ... I Refunded .,. 35 

Please Under penalties of perjury, I declare that I have examined this return, including accon:ipanying schedules and statements, and to the best of my knowledge and 

belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) 1s based on all information of which preparer has any knowledge. 

Sl1n 

~ Signature of officer 

I Here Date ~ Title 

Preparer's ~ I Date 

I 

Check if I Preparer's social security number Paid self-em- D ! ! 

,,.,.,.,., 

signature ployed .,. i : 

Use Only Firm's name (or 

~ I E.I. No. ... yours, if self-employed) 

and address I ZIPcode ... 
Form 1120 (1983) 

SCHEDULE A.-Cost of Goods Sold 

(See instructions for Schedule A) 

1 Inventory at beginning of year. 

2 Merchandise bought for manufacture or sale . 

3 Salaries and wages 

4 Other costs (attach schedule). 

5 Total-Add lines 1through4 . 

6 Inventory at end of year. 

7 Cost of goods sold-Subtract line 6 from line 5. Enter here and on line 2, page 1 

8 (•) Check all methods used for valuing closing inventory: 

(i) D Cost 

(ii) D Lower of cost or market as described in Regulations section 1.471-4 (see instructions) 

1 

2 

3 

4 

5 

6 

7 

(iii) D Writedown of "subnormal" goods as described in Regulations section l.471-2(c) (see instructions) 

Page2 

(iv) D Other (Specify method used and attach explanation) ..,. _________________________________________________________ _ 

(b) Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970) . . . . . D 

(c) If the LIFO inventory method was used for this tax year, enter percentage (or amounts) of closing inventory 

computed under LIFO . . . . . . . . . . . . . . . . . . . . . . . . . . .. . 

(d) If you are engaged in manufacturing, did you value your inventory using the full absorption method (Regulations section 1.471-11)? . . . . . . . . . . . . . . . . . . . . . . . . . . . . D Yes D No 

(e) Was there any substantial change in determining quantities, cost, or valuations between opening and closing inventory? D Yes D No 

If "Yes," attach explanation. 

SCHEDULE C.-Dlvldends and Special Deductions (A) Dividends (C)Special 

(See instructions for Schedule C) received (8)% deductions: multiply 

(A) X (8) 

1 Domestic corporations subject to 85% deduction 85 

2 Certain preferred stock of public utilities 59.13 

3 Foreign corporations subject to 85% deduction 85 

4 Wholly-owned foreign subsidiaries subject to 100% deduction (section 245(b)) 100 

5 Total-Add lines 1 through 4. See instructions for limitation 

6 Affiliated groups subject to the 100% deduction (section 243(aX3)) 100 

7 Other dividends from foreign corporations not included in lines 3 and 4 

8 Income from controiied foreign corporations under subpart F (attach Forms 5471) 

9 Foreign dividend gr0ss-up (section 78) 

10 DISC or former DISC dividends not included in line 1 (section 246(d)) 

11 Other dividends 

12 Deduction for dividends paid on certain preferred stock of public utilities (see 

instructions) 

13 Total dividends-Add lines 1 through 11. Enter here and on line 4, page 1 .... 

14 Total deductions-Add lines 5, 6 and 12. Enter here and on line 29(b), page 1 ..... 

SCHEDULE E.-Compensation of Officers (See instruction for line 12, page 1) 

Complete Schedule E only if your total receipts (line l(a), plus lines 4 through 10, of page 1, 1- orm 1120) are $150,000 

or more. 

3. Percent of time Percent of corporation 

1. Name of officer 2. Social security number devoted to stock owned 6. Amount of compensation 

business 4. Common 5. Preferred 

% % % 

% % % 

% % % 

% % % 

% % % 

% % % 

% % % 

Total compensation of officers-Enter here and on line 12, paRe 1 . 

SCHEDULE F .-Bad Debts-R eserve Met h od (S ee instruction or line 15, page 1) 

1. Year 2. Trade notes and accounts 3. Sales on Amount added to reserve 6. Amount charged 7. Reserve for bad 

receivable outstandi~ at end of year account 4. Current year's provision 5. Recoveries against reserve debts at end of year 

1978 

1979 

1980 

1981 

1982 

1983 

-- -= 
Form 1120 (1983) 

SCHEDULE J.-Tax Computation 

See instructions for Schedule J on a e 7 

1 Check if you are a member of a controlled group (see sections 1561 and 1563) . . . . . . . .1111> D 

2 If line 1 is checked, see instructions and enter your portion of the $25,000 amount in each taxable income 

bracket: 

(i) S _ _ _ _ _ _ _ _ _ _ _ _ _ (ii) S _ _ _ _ _ _ _ _ _ _ _ _ _ (iii) $ _ _ _ _ _ _ _ _ _ _ _ _ _ (iv) $ ____________ _ 

3 Income tax (see instructions to figure the tax; enter this tax or alternative tax from Schedule D, whichever is 

less). Check if from Schedule D 1111> O . . . . . . . . . . 3 

4 (•) Foreign tax credit (attach Form 1118). 

(b) lnvest~ent credit (attach Form 3468) 

(c) Jobs credit (attach Form 5884). . . 

(d) Employee stock ownership credit (attach Form 8007) . 

(•) Research credit (attach Form 6765) . . 

(f) Possessions tax credit (attach Form 5735) . . . . 

(C) Alcohol fuel credit (attach Form 6478) . . . . .. 

(h) Credit for fuel produced from a nonconventional source (see instructions) 

5 Total-Add lines 4(a) through 4(h) . 5 

6 Subtract line 5 from line 3 . . . . 6 

7 Personal holding company tax (attach Schedule PH (Form 1120)) . 7 

8 Tax from recomputing prior-year investment credit (attach Form 4255) 8 

9 Minimum tax on tax preference items (see instructions-attach Form 4626) 9 

10 Total tax-Add lines 6 through 9. Enter h4!re and on line 31, page 1 10 

Additional Information (See page 8 of instructions) Yes No 

H Did you claim a deduction for expenses connected with: 

(1) Entertainment facility (boat, resort, ranch, etc.)? . . 

(2) living accommodations (except employees on business)? 

(3) Employees attending conventions or meetings outside the 

North American area? (See section 274(h)) 

(4) Emp oyees' families at conventions or meetings? . . . 

If "Yes," were any of these conventions or meetings outside 

the North American area? (See section 274(h)) . . . . 

(5) Employee or family vacations not reported on Form W-2? . 

(1) 

(2) 

Did you at the end of the tax year own, directly or indirectly, 

50% or more of the voting stock of a domestic corporation? 

(For rules of attribution, see section 267(c).) . . . . . 

If "Yes," attach a schedule showing: (a) name, address, and 

identifyin number; (b) percentage owned; (c) taxable income or 

(loss) before NOL and special deductions (e.g., If a Form 1120: 

from Form 1120, line 28, page 1) of such corporation for the tax 

year ending with or within your tax year; (d) highest amount owed 

by you to such corporation during the year ; and (e) highest 

amount owed to you by such corporation during the year. 

Did any individual, partnership, corporation, estate or trust at 

the end of the tax year own, directly or indirectly, 50% or more 

of your voting stock? (For rules of attribution, see section 

267(c).) If "Yes " complete (a) through (e) . . . . . . 

(a) Attach a schedule showing name, address, and identifying 

number. 

(b) Enter percentage owned 1111> _______ __________ _ 

(c) Was the owner of such voting stock a person other than a 

U.S. person? (See instructions). . . . . . . . 

If "Yes," enter owner's country 1111> ___________ _ 

(d) Enter highest amount owed by you to such owner during 

the year 1111> 

(e) Enter highest amount owed to you by such owner during 

the year 1111> _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _______ _ 

(Note: For purposes of 1(1) and 1(2), "highest amount owed" includes 

loans and accounts receivable/payable.) 

J Refer to page 9 of instructions and state the principal: 

Business activity 1111> __________________________ _ 

Product or service 1111> 

K Were you a U.S. shareholder of any controlled foreign corporation? 

(See sections 951 and 957.) If "Yes," attach Form 5471 for each 

such corporation. 

L At any time during the tax year, did you have an interest in or a 

signature or other authority over a bank account, securities account, or 

other financial account in a foreign country? (See page 8 for exceptions 

and filin& requirements for Form 90-22.1.) . . . . . 

If "Yes," write the name of the foreign country 1111> ___________ _ 

----------------------- ------- ---------- M Were you the grantor of, or transferor to, a foreign trust which 

existed during the current tax year, whether or not you have any 

beneficial interest in it? . . . . . . . . . . . . 

If "Yes," you may have to file Forms 3520, 3520-A or 926. 

N During this tax year, did you pay dividends (other than stock dividends 

and distributions in exchange for stock) in ex~ss of your current and 

accumulated earnings and profits? (See sections 301 and 316) . . . 

If "Yes,"· file Form 5452. If this is a consolidated return, answer 

here for parent corporation and on Form 851, Affiliations Schedule 

for each subsidiary. ' 

0 During this tax year did you maintain any part of your accountini/ 

tax records on a computerized system? . . . . . . . 

P Check method of accounting: ( 1) D Cash (2) D Accrual 

(3) Other (specify) 1111> 
form 1120(1983) 

SCHEDULE L.-Balance Sheets 

Assets 

1 Cash 

2 Trade notes and accounts receivable 

(a) Less allowance for bad debts 

3 Inventories . . . . . . . . 

4 Federal and State government obligations 

5 Other current assets (attach schedule) 

6 Loans to stockholders . . . . . 

7 Mortgage and real estate loans . . . 

8 Other investments (attach schedule) . 

9 Buildings and other depreciable assets 

(a) Less accumulated depreciation 

10 Depletable assets . . . . . 

(a) Less accumulated depletion 

11 Land (net of any amortization) . 

12 Intangible assets (amortizable only) 

(a) Less accumulated amortization 

13 Other assets (attach schedule) . . 

14 Total assets . . . . . . . . 

Llabllltles and Stockholders' Equity 

15 Accounts payable . . . . . . . 

16 Mortgages, notes, bonds payable in less than 1 year 

17 Other current liabilities (attach schedule) . . 

18 Loans from stockholders . . . . . . . 

19 Mortgages, notes, bonds payable in 1 year or more 

20 Other liabilities (attach schedule) 

21 Capital stock: (a) Preferred stock 

(b) Common stock 

22 Paid-in or capital surplus . . . 

23 Retained earnings Appropriated (attach scheaule) 

24 Retained earnings Unappropriated . 

25 Less cost of treasury stock . . . . . . 

26 Total liabilities and stockholders' equity . . 

Beginning of tax year End of tax year 

(A) (B) (C) 

SCHEDULE M·l.-Reconclllatlon of Income Per Books With Income Per Return 

Do not complete this schedule if your total assets (line 14, column (0), above) are less than $25,000. 

1 Net income per books. 7 Income recorded on books this year not includ· 

2 federal income tax ed in this return (itemize) 

3 Excess of capital losses over capital gains (a) Tax·exempt interest $ ____________ , _ 

4 Income subject to tax not recorded on books this year ________ ____________ _____________ _ 

(itemize) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ________________________________ _ 

5 Expenses recorded on books this year not deducted in 

this return (itemize) 

(a) Depreciation . $ _________________ _ 

(b) Contributions carryover $ _________________ _ 

6 Total of lines 1 throuah 5. 

8 Deductions in this tax return not charged 

against book income this year (itemize) 

(a) Depreciation $ __________ _ 

(b) Contributions carryover $ __________ _ 

9 Total of lines 7 and 8 . 

10 Income (line 28, page 1)-line 6 less line 9. 

SCHEDULE M-2.-Analysls of Unappropriated Retained Earnings Per Books (line 24 above) 

Do not complete this schedule if vour total assets (line 14, column (0), above) are les~ than $25,000. 

1 Balance at beginnin& of year . . . . . . . . 5 Distributions: (a) Cash . . 

(b) Stock . . . . . . 

Page 4 

(D) 

2 Net income per books. . . . . . . . . . .,___ _____ _ 3 Other increases (itemize) _____________________ _ (c)..Property. . . . . . .,___ _____ _ 6 Other decreases (itemize) ______________ _ 

7 Total of lines 5 and 6 . . . . 

4 Total of lines 1, 2, and 3 . . . . . . . 8 Balance at end of year (line 4 less line 7) . . 
F~rm 5735 

(Rev. March 1984) 

Department of the Treasury 

Internal Revenue Service 

Computation of Possessions Corporation 

Tax Credit Allowed Under Section 936 OMB No. 1545-0217 

Expires 3/ 31/87 

• Attach to your tax return 

For calendar year 19 - -- - -or other tax year beginning_ ---------------------,19 - - --, and ending -----------------------' 19 - -- - ... 

Name Employer identification number 

limlll Gross Income in Applicable Period 

Tax year (Use a separate line for each tax year Name of U.S. possession in which trade or Periods in which trade or business was actively 

ending with or within your applicable period. Start business was actively conducted conducted in a U.S. possession (Dates are 

with the earliest such tax year. See instruction 8.) inclusive) 

Beginning Ending 

(a) (b) (c) 

Gross Income during periods shown in columns (d) and (e) 

Gross income from the active conduct of a trade or business in a U.S. possession 

From sources in U.S. From all other sources From sources in 

possessions outside the U.S. the U.S. 

f h 

Gross qualified 

possession source 

investment income From sources in U.S 

possessions 

From-

(d) 

All other gross income 

From all other sources 

outside the U.S. 

k 

To-

(e) 

From sources in the 

U.S. 

I 

1 Total gross income in applicable period (add totals of columns (f) through (I)) ,__1---i-------

2 Gross income in applicable period from sources in U.S. possessions (add total of columns (f), (i), and U)) ,__2---i-------

3 Divide line 2 by line 1 (if less than 80%, do not complete Parts II and Ill). ,__3---it--------

4 Gross income from the active conduct of a trade or business in a U.S. possession (total of columns (f), (g), and (h)). 1--4---11--------

5 Divide line 4 by line 1 (if less than 55%, do not complete Parts II and Ill). 5 

Computln the Possessions Corporation Tax Credit 

6 Qualified gross income in current year: 

(a) From sources outside the U.S. from the active conduct of a trade or business in a U.S. 

possession (see instructions) . 1-6_(_a_) r-------

(b) From sources outside the U.S. from the sale or exchange of substantially all assets 

used in a possessions trade or business . 

(c) Gross qualified possession source investment income 

(d) Amounts received in the U.S. 

(e) Intangible property income subject to section 936(h)(2) 

(f) Other intangible property income (see instructions) . 

(g) Add lines 6(a), 6(b), and 6(c) · 

(h) Add lines 6(d), 6(e), and 6(f) . 

(i) Subtract line 6(h) from 6(g) 

7 Applicable deductions (attach schedule): 

(a) Cost sharing amount (see instructions) 

(b) Definitely allocable deductions (see instructions) 

(c) Ratable part of deductions not definitely allocable 

(d) Total (add lines 7(a), 7(b) and 7(c)) . 

6 

6(h) 

7(a) 

7(b) 

7(c) 

8 Qualified taxable income before loss adjustments (line 6(i) less line 7(d)). If loss, do not complete below . 

9 Loss adjustments (attach schedule): 

(a) Current ye~r losses from non-qualified sources (see instructions) . t-9-'(_a'-) +---------

(b) Recapture of prior year overall foreign l°'sses (see instructions) t-9-'(_b'-) +---------

(c) Net capital loss or short-term capital loss adjustment (see instructions) ~9_(_c)'-'-----...----1 

(d) Total (add lines 9(a), 9(b), and 9(c)) . 1-9_(d--'-)-+-------

10 Qualified taxable income (subtract line 9(d) from line 8) . ,___10__.. _____ _ 

11 Total taxable income from all sources (enter taxable income from your tax return) ,__1_1-+-------

12 Adjustments to taxable income from all sources (see instructions) ,__1_2-+-------

13 Subtract line 12 from line 11 ,__1_3-+-------

14 Divide line 10 by line 13 ,__1_4-+-------

15 Total U.S. income tax against which section 936 credit is allowed (see instruction C) ,__1_5-+-------

16 Section 936 credit (multiply line 14 by line 15). Enter here and on your tax return .,.. 16 

For Paperwork Reduction Act Notice, see instructions on back. Form 5735 (3-84) 
From Schedule P See instructions 

17 Enter the total sales of possession products to which each income method applies: 

(a) Cost sharing method 

(b) Profit split method 

Page 2 

18 Enter the total sales of possession products which qualify under each business presence test: 

(a) Start-up value-added test 

(b) 25% value-added test 

(c) Start-up labor test 

(d) 65% labor test 

(e) 50· 70% labor /construction test 

(f) None of the above 

Instructions 

(Section references are to the Internal Revenue 

Code, unless otherwise noted) 

Paperwork Reduction Act Notice.-We ask for 

this information to carry out the Internal Revenue 

laws of the United States. We need it to ensure 

that taxpayers are complying with these laws and 

to allow us to figure and collect the right amount 

of tax . You are required to give us this infer· 

mat1on. 

New Law.-Effective for tax years beginning 

after 1982, new rules apply to the intangible 

property income of a possessions corporation. 

See section 936(h) and Form 5712-A, Election 

to Use the Cost Sharing or Profit Split Method 

Under Section 936(h)(5). Also see Schedule P 

(Form 5735), Allocation of Income and Expenses 

Under Section 936(h)(5). 

General Instructions 

A. Purpose of Form .-A domestic corporation 

that has elected to be treated as a possessions 

corporation must attach Form 5735 to its income 

tax return for each year that the election is in 

effect. Complete Form 5735 to figure the 

possessions corporation tax credit under section 

936. The credit is allowed against income tax 

imposed by Chapter l. Puerto Rico is a U.S. 

possession for purposes of this credit, but the 

Virgin Islands are not. 

B. Qualifying for the Credit.-To qualify for the 

possessions tax credit, a corporation must: 

(1) have filed a valid Form 5712, Election to be 

Treated as a Possessions Corporation Under Section 936; 

(2) have derived 80% or more of its gross in· 

come from sources in a U.S. possession during 

the applicable period immediately before the tax 

year ended; and 

(3) have derived 55% (for taxable years beginning in 1983) or more of its gross income from 

the active conduct of a trade or business in a U.S. 

possession during the applicable period immediately before the tax year ended. (The 55% is 

increased to 60% for taxable years beginning in 

1984, and to 65% for taxable years beginning in 

1985 and thereafter.) 

The "applicable period" is generally the shorter 

of 36 months or the period when the corporation 

actively conducted a trade or business in a U.S. 

possession. 

C. Restrictions.-A corporation is ineligible to 

take the possessions tax credit for any tax year it 

is a DISC or former DISC, or for any tax year in 

which it owns stock in a DISC or former DISC 

(section 936(f)). 

The credit is not allowed against the following 

taxes: 

• minimum tax on tax preference items 

(section 56). 

• tax on accumulated earnings (section 531). 

• personal holding company tax (section 541). 

• additional tax for recovery of foreign 

expropriation losses (section 1351). 

• tax increase on the early disposition of 

investment credit property (section 4 7). 

• tax on certain capital gains of S corporations 

(section 1374). 

D. Where to File.-Attach Form 5735 to your 

income tax return and file your return with the 

Internal Revenue Service Center, Philadelphia, 

PA 19255. 

Specific Instructions 

Follow sections 638, 861-864 and 936 to determine if the source of gross income, deductions, 

and taxable income is in or outside the U.S. or in 

a U.S possession . If you receive any income in 

the U.S., regardless of its source, do not include 

it as income from sources outside the U.S. (section 936(b)). 

You cannot take a deduction or foreign tax 

credit for taxes you paid or accrued to a foreign 

country or U.S. possession, if any of the income on 

which those taxes were paid or accrued is used in 

computing the possessions corporation tax credit. 

Part I 

Column (f).-Enter the gross income from the 

active conduct of a trade or business in a U.S. 

possession which is from sources in U.S. 

possessions. Include amount(s) reported on line 

6 of Part II of Schedule(s) P. 

Column (i).-Enter gross qualified possession 

source investment income in column (i). See section 936(d)(2). 

Part II 

Line 6(a).-lnclude amount(s) reported on line 6 

of Part II of Schedule(s) P. 

Line 6(b).-lnclude gross income that came 

from sources outside the U.S. from selling or exchanging substantially all the assets the possessions corporation used in the active conduct of its 

trade or business. 

Line 6(f).-Enter the amount of marketing 

intangible property income which is associated 

with any product(s) subject to the cost sharing 

method and which is not included in the gross income of a shareholder because such shareholder 

is a foreign person or a tax-exempt U.S. person. 

See proposed regulations section l.936-6(a)(5). 

Line 7(a).-lnclude the sum of all cost sharing 

amounts entered on line 7 of Part I of 

Schedule(s) P if the cost sharing method applies. 

Line 7(b).-lnclude all amounts entered on line 

7 of Part II of Schedule(s) P. Also include the 

reduction for the 'rate differential portion' (as 

defined in section 904(b)(3)(F)) of any net 

capital gain that comes from a foreign source and 

is included on line 6(i). Also include the corporation's other definitely allocable deductions. 

Line 7(c).-Enter on line 7(c) the ratable part of 

deductions that cannot be definitely allocated to 

qualified income. To obtain this figure, reduce 

the deductions by the amount entered on line 

7(b). Multiply this result by the 2mount obtained 

when you divide the amount entered on line 6(i) 

by the gross income on your income tax return. 

Line 9(a).-lf you sustain a loss for the current 

year in the U.S. or on any type of income for 

which a separate foreign tax credit limit applies, 

allocate the loss to possessions income that 

qualifies for the credit in proportion to the ratio of 

that income to total taxable income, excluding 

the loss. 

Line 9(b).-lf you sustain an overall foreign loss 

in any year, the loss is recaptured in later tax 

years by treating part of your taxable income from 

sources outside the U.S. as income from sources 

in the U.S. (section 904(f)). 

Line 9(c).-To the extent any net capital loss or 

short-term capital loss from sources outside the 

U.S. is used to determine capital gain net income, 

it is also used to reduce income against which the 

credit is allowed . First, however, decrease the 

loss by the "rate differential portion" of the excess of net capital gain from non-qualified 

sources over net capital gain. Enter on line 9(c) 

the al"lount by which the loss reduces the corporation's income that qualifies for the credit. Attach your computation. 

Line 12.-lf line 11 includes income from selling 

or exchanging capital assets, include the reduc-

. tion for the "rate differential portion" of net 

capital gain. 

Part Ill. 

You are not required to complete Part Ill if you 

have attached fewer than 10 Schedules P. Part Ill 

information will not affect your tax liability, but 

failure to complete this part, if you are required to 

do so, will delay the processing of your Form 

5735. 

Line 17 .-Enter on line l 7(a) the sum of sales of 

possession products (as reported on line 2 of Part 

I of Schedule(s) P) subject to the cost sharing 

method. Enter on line l 7(b) the sum of sales of 

possession products (as reported on line 2 of Part 

I of Schedule(s) P) subject to the profit split 

method. 

Line 18.-Enter on lines 18(a) through 18(f) the 

sum of sales of possession products (as reported 

on line 2 of Part I of Schedule(s) P) which have 

met the listed business presence test. Total sales 

included on lines 18(a) through 18(f) should 

equal the total of lines l 7(a) and l 7(b). 
SCHEDULE P 

(Form 5735) 

(March 1984) 

Department of the Treasury 

Internal Revenue Service 

Allocation of Income and Expenses 

Under Section 936(h)(5) 

.,. Attach to Form 5735 

OMB No. 1545-0217 

Expires 3/31/87 

Attach a separate Schedule P for each product to which the cost sharing or profit split method under section 936(h)(5) applies. 

Name as shown on rorm 5735 Employer identification number 

Identify the product reported on this schedule . (See proposed regulations section l.936-5(a).) ..,.. ________________ _____ ______ . 

Check the box next to the b<.Js1ness pre~ence test under which the product qualifies, and show computations on an attached schedule. (See 

pr~osed regulations section 1.936-5(a) and (b).) 

,__, Start-up value-added test (for a new product only) 

D 25% value-added test 

D Start-up labor test (for a new product only) 

D 65% labor test 

0 50-70% labor /construction test 

0 None of the above (see proposed regulations section l.936-5(b)) 

To be completed by all taxpayers. 

1 Product area research (see instructions) . . . . . . 

2 Sales of the poss·ess1on product (see 1nstruct1ons) . . . 

3 Sales of all products in the product area (see instructions) 

4 Cost sharing fraction (divide line 2 by line 3) 

5 Gross cost sharing amount (multiply line 1 by line 4) 

6 Reductions (see instructions) . . . . . . 

7 Net cost sharing amount (subtract line 6 from line 5). Enter here. If the cost sharing method applies, also 

include on line 7(a) of Part II of Form 5735 and on line 26, page 1, Form 1120 of the possessions corporation 

To be completed for profit split method only. 

Combined Taxable Income from the Possession Product: 

-1 Combined gross receipts . . . . . . . . . . . . . . . . . . . . . . . . . . 

2 Combined cost of goods sold 

(a) Inventory at beginning of year . . . . . . . . . . 

(b) Merchandise bought for manufacture . . . . . . . 

(c) Salaries and wages allocable or apportionable to the product 

(d) Other costs (attach schedule) . . 

(e) Total (add lines 2(a) thrvugh 2(d)) 

(f) Inventory at end of year 

(g) Cost of goods sold (subtract line 2(f) from line 2(e)) . 

3 Combined gross income (subtract line 2(g) from line 1) . 

4 Other combined expenses allocable or apportionable to the product 

(a) Marketing . . . . . . . . . 

(b) Cost sharing amount from line 7, Part I 

(c) Research and development expenses 

(d) Enter the greater of line 4(b) or 4(c) 

(e) Other deductions (attach schedule) . 

(f) Total (add lines 4(a), 4(d), and 4(e) . 

5 Combined taxable income (subtract line 4(f) from line 3) 

4(b) 

4(c) 

6 Posc:essions corporation's gross income from the product (50% of line 3). Enter here and include in column 

(f) of Part I of Form 5735, and on line 6(a) of Part II of Form 5735 . . . . . . . . . . . . . . 

7 Possessions corporation's applicable deductions (50% of line 4(f)). Enter here 'and include on line 7(b) of 

Part II of Form 5735 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 

8 Possessions corporation's taxable income from the product (50% of line 5)1 Enter here and include on line 

10, page 1, Form 1120 of the possessions corporation . . . . . . . . . . . . . . . . 

1 

2 

3 

4 

5 

6 

7 

4(d) 

4(e) 

4(f) 

5 

6 

7 

8 

For Paperwork Reduction Act Notice, see Form 5735 Instructions. Schedule P (Form 5735) (3-84) 
Schedule P (Form 5735) (3-84) Page 2 

i:F.hihi To b e completed for ~flt split method only - 1 Adjustment to research deduction. Enter line 4(b) minus line 4(c) of Part II, but not less than zero 1 

2 Enter line 5 of Part ll 2 

3 Enter line 8 of Part IL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 

4 Combir.ed taxable income to be allocated below to U.S. affiliates (Enter line 1 plus line 2 minus line 3) 4 

S c e h d ue I of affiliates' shares of combined taxable Income reported on line 4 of Part 111 

(c) Amount of share. Enter here and 

(a) Name of affiliate (b) Identifying number include on line 10, page l, Form 

1120 of the appropriate affiliate. 

----··--

1~1~Tobecom~etedforcostsharin&~~e~th~o~d~o~n~l~y~.------------------------­

S c h d e ue I of a ffiliates' shares of cost sharing amount and marketing intangible Income -- ··- -- ------ (c) Share of cost sharing amount. (d) Share of marketing intangible 

(b) Identifying number Enter here and reduce line 26, page income. Enter here and include on (a) Name of affi:oate 1, Form 1120 of the appropriate line 10, page 1, Form 1120 of the 

·--·---------

I r1structions 

(Section references are to the Internal Revenue Code, unless 

otherwise noted.) 

Purpose of Schedule.--Schedule P must be attached to 

Form 5735 by a possessions corporation which ~as el.ected 

to use either the cost sharing method or the profit spltt 

method of computing taxable income under section 

936(h)(5). 

Specific Instructions 

A separate Schedule P must be filed f~r ea~h product to 

which the cost sharing method or profit spltt met~od under 

section 936(h)(5) applies. If you have elected a different 

method for export sales than for domestic sale~ of the 

possession product, two Schedules P must be filed for that 

product. All taxpayers must complete .Part I. Complete Parts 

II and Ill if the profit split method applies to the product. 

Complete Part IV if the cost sharing method applies to the 

product. 

Part I 

line 1.-Enter the amount of product area research 

expenditures incurred by the P.ossessions corporatio~.and all 

other members, including foreign persons, of the aff11tated 

group within the meaning.of section 48.2. Product are~ 

research includes expenditures deductible under section 

174; qualified research expenses within the meaning of 

section 44F(b); and certain other expenditures. See 

proposed regulations section 1.936-G(a)(l). 

affiliate by this amount. appropriate affiliate. 

Part II 

Use this Part to compute the combined taxable income of 

the possessions corporation and its U.S. affiliates derived 

from the possession product. 

line 1.-Enter the combined gross receipts from the sale or 

other disposition of the possession product by the 

possessions corporation and its U.S. affiliates to unrelated 

persons or foreign affiliates. 

Line 2.-Enter the sum of the costs of goods sold of the 

possessions corporation and of its U.S. affiliates which are 

attributable to the possession product. 

Line 4.-Enter the sum of the expenses incurred by the 

possessions corporation and by its U.S. affiliates which are 

allocable or apportionable to the possession product. 

Note: The share of combined taxable income of the 

possessions corporation entered on line 8 of Part II should be 

reported on line 10, page 1, Form 1120 of the possessions 

corporation. The shares of combined taxable income of the 

U.S. affiliates entered in column (c) of Part Ill should be 

reported on line 10, page 1, Form 1120 of each affiliate. 

Gross receipts, costs of goods sold, and expenses of the 

possessions corporation and its affiliates which are included 

in Part II should not be reported o.n any Form 1120 filed by 

the possessions corporation or its affiliates. 

Part Ill 

The amount on line 4 will be allocated to the members of the 

Line 2.-Enter the total sales or other dispositions of the affiliated group in accordance with proposed regulations 

possession product by the affiliated group to persons who are section l.936-6(b)(l). The total of column (c) should equal 

not members of the affiliated group. See proposed regula- the amount entered on line 4, Part Ill. 

tions section 1.936-6(a)(2). 

Line 3.-Enter the total sales or other dispositions of all 

products in the product area by the affiliated group to 

persons who are not members of the affiliated group. 

Line 6.-Enter the amount of product area research 

expenditures paid or accrued solely by the possessions 

corporation. However, do not include amounts paid or 

accrued to or on behalf of related persons and amounts paid 

or accrued under any cost sharing arrangement with a 

related person. 

Part IV 

Enter in column (c), Part IV the share of the cost sharing 

amount (computed in line 7 of Part I) which is allocated to 

each of the members of the affiliated group in accordance 

with proposed regulations section l.936-6(a)(5). Also use 

column (d), Part IV to enter the share of marketing intangible 

income which is allocated to each of the members of the 

affiliated group in accordance with proposed regulations 

section 1.936-6(a)(5). 
Form 5712 

(Rev. March 1984) 

Department of the Treasury 

Internal Revenue Service 

Election to be Treated as a 

Possessions Corporation Under Section 936 

(Do NOT Attach to Your Tax Return-Fiie Separately) 

The corporation named below elects under section 936(e) of the Internal 

Revenue Code to be treated as a possessions corporation for income tax purposes. 

OMB No. 1545-0215 

Expires 4-30-87 

Name of corporation Employer identification number 

Number and street Date of incorporation 

City or town, State and ZIP code Place of incorporation 

Business code number 

I 

Principal business activity Principal product or service 

Number of shares 

Description of each class of stock of each class 

issued and outstanding 

Submit the following information for each shareholder who owns 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 

Election takes effect for the tax year beginning (month, day, year) Date corporation began business in a U.S. Annual return will be filed for the tax year ending (enter 

possession the month or "unknown") 

Under 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 of my 

knowledge and belief, true, correct, and complete. . 

-------------------------------------~----------------------------------------------------------- ------------------------ Signature and title of officer Date 

for Paperwork Reduction Act Notice, see Instructions on back. Form 5 712 (Rev. 3·84) 
Form 5712 (Rev. 3-84) 

Instructions 

(Section references are to the Internal Revenue Code, 

unless otherwise noted.) 

Paperwork Reduction Act Notice 

We ask for this information to carry out the Internal 

Revenue laws of the United States. We need it to ensure 

that taxpayers are complying with these laws and to allow 

us to figure and collect the right amount of tax. You are 

required to give us this information. 

Who Can Elect 

Only domestic corporations can elect to be treated as 

possessions corporations. 

When to File 

File Form 5712 by the due date (including extensions) 

of the first return to which the election is to apply. 

Where to File 

File this form with the Internal Revenue Service Center, 

Philadelphia, PA 19255. File it separately from your regular 

income tax return. 

U.S. Possessions 

For purposes of this election, U.S. possessions include 

Puerto Rico but not the Virgin Islands. 

Period of Election 

The election applies to the first tax year for which such 

election was made and for which the domestic corporation 

qualifies under section 936(a). 

Generally, to revoke this election for any tax ~ear that 

starts within 9 tax years after the tax year for which the 

election takes effect, you need the Commissioner's 

Page 2 

consent. However, the Commissioner will consent to all 

requests for revocation that are made with respect to your 

first taxable year beginning after 1982, provided that you 

agree not to re-elect section 936(a) prior to your first 

taxable year beginning after 1988. This can be done by 

attaching a 'statement of revocation -- section 936' to your 

timely filed return (including extensions) in which you state 

that you will not re-elect section 936(a) prior to your first 

taxable year beginning after 1988. (See proposed 

regulation l.936-7(c).) 

Form 5735 

For every year the election is in e-ffect, you must 

complete Form 5735, Computation of Possessions 

Corporation Tax Credit Allowed 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 this election 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 (1) the 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 accounting 

officier, or other corporate officer (such as tax officer) who 

is authorized to sign. 
Form 5712•A 

(March 1984) 

Department of the Treasury 

Internal Revenue Service 

Election to Use the Cost Sharing or Profit 

Spllt Method Under Section 936(h)(5) 

..,. Attac'!1 to your tax return. 

OMB No.1545-0215 

Expires 4-30-87 

The corporation named below elects under section 936(hX5) of the Internal Revenue Code to use the cost sharing method or profit split 

method for income tax purposes. The election takes effect for the possessions corporation's first tax year beginning after December 31, 

1982. 

Name of corporation Employer identification number 

lml Cost Sharing Method 

Check appropriate box(es) 

SIC Code Domestic Sales Export Sales 

List the product area(s) by SIC code to which the election to use LJ LJ the cost sharing method will apply. LJ LJ 

LJ LJ 

1@111 Profit Split Method 

Check appropriate box(es) 

SIC Code Domestic Sales Export Sales 

List the product area(s) by SIC code to which the election to use LJ LJ the profit split method will apply. LJ LJ 

LJ LJ 

1@1111 List all other persons In the afflllated group, Including foreign afflllates. 

Name of affiliated possessions corporations Identifying number SIC Code(s) 

Name of other affiliates Identifying number SIC Code(s) (if none, enter address) 

Under penalties of perjury, I declare that I have been duly authorized by the above-named corporation to make this election, and that to the 

best of my knowledge and belief, the statements made are true, correct, and complete; and that I have received signed statements in 

which an authorized officer of each corporation listed in Part Ill consents to the above.election. 

Signature and title of officer of electing corporation Date 

For Paperwork Reduction Act Notice, see Instructions on back. Form 5712-A (3-84) 
Form 5712-A (3·84) 

Instructions 

(Section references are to the Internal Revenue Code.) 

Paperwork Reduction Act Notice 

We ask for this information to carry out the Internal Revenue 

laws of the United States. We need it to ensure that taxpayers are complying with these laws and to allow us to 

figure and collect the right amount of tax. You are required to 

give us this information. 

New Law 

Effective for tax years beginning after 1982, new rules apply 

to the intangible property income of possessions corporations. Generally, this type of income (defined in section 

936(h)(3)) is to be included in the gross income of the U.S. 

stiareholders of a possessions corporation. However, the 

possessions corporation may elect out of this tax treatment if 

it satisfies a significant business presence test for products 

within a specific product area, or if it was producing the product in a possession on or before September 3, 1982. The 

possessions corporation may elect either the cost sharing 

method or the profit split method of computing taxable income. 

If the cost sharing method is elected for a product area, 

the possessions corporation will be required to make a cost 

sharing payment which will reduce the amount of deductions 

otherwise allowable to the appropriate affiliates. 

If the profit split method is elected for a product area, the 

possessions corporation will be required to compute the combined taxable income of the possessions corporation and its 

U.S. affiliates derived from sales of the products within such 

product area. Fifty percent of the combined taxable income 

will be allocated to the possessions corporation, and the remainder will generally be allocated to the appropriate affiliates. 

Purpose of Form 

You must file this form if you elect to use the cost sharing 

method or the profit split method of computing taxable income under section 936(h)(5). 

Who Can Elect 

Only domestic corporations which have completed Form 

5712, Election to be Treated as a Possessions Corporation 

Under Section 936, may elect to use the cost sharing or profit split method under section 936(h)(5). 

When to File 

Form 5712-A must be filed on or before the due date 

(including extensions) of the return for your first tax year 

beginning after December 31, 1982. 

Page 2 

Where to File 

Attach this form to your regular income tax return and file 

your return with the Internal Revenue Service Center, 

Philadelphia, PA 19255. 

Scope of Election 

An election to use the cost sharing method or profit split 

method covers all products in a product area. A product area 

is defined by reference to the three-digit classification of the 

Standard Industrial Classification (SIC) code. See the Standard Industrial Classification Manual. You may make different elections for different product areas. In addition, you 

may choose whether an election for a given product area 

covers all sales, domestic sales only, or export sales only, of 

products produced in the product area. 

Note: All possessions corporations in an affiliated group 

within the meaning of section 482 that produce any products 

in a given product area must make the same election for that 

product area. You must list in Part Ill the name and employer 

identification number (or address if taxpayer does not have a 

EIN) of all members of the affiliated group (including foreign 

affiliates not required to file a U.S. return). All members of 

the affiliated group must consent to the election. If 

subsequent to filing Form 5712-A, there are changes in the 

make-up of the affiliated group, an amended Form 5712-A 

must be filed by attaching it to the possessions corporation's 

timely filed tax return (including extensions). 

Period of Election 

Once an election is made, it is binding and must be used for 

each taxable year in which the domestic corporation qualifies 

under sections 936(a) and (h)(5) until revoked. 

In general, you may revoke this election only with the consent of the Commissioner. However, you may change your 

election for any product area once (from the cost sharing 

method to the profit split method, or vice versa) without the 

consent of the Commissioner if the change is made before 

the later of the following dates: 

(a) January 1, 1986, or 

(b) 90 days after the date of publication of final regulations 

under section 936(h)(5)(C)(i) and (ii). 

Signature 

This form must be signed by the president, vice president, 

treasurer, assistant treasurer, chief accounting officer, or 

other corporate officer (such as tax officer) who is authorized 

to sign. 
Form 940 Employer's Annual Federal OMB No. 1545-0028 

Department of the Treasury Unemployment {FUTA) Tax Return ll@83 Internal Revenue Service .,.. For Paperwork Reduction Act Notice, see page 2. 

T 

!Name (as distinguished from trade name) Calendar Year I FF 

1983 f'L) 

If Incorrect, 

~ Trade name, if any Employer identification number FP make any 

neceuary I 

chan1e. Address and ZIP code T 

L _J 

A Did you pay all required contributions to your State unemployment fund by the due date of Form 940? 

If you check the "Yes" box, enter amount of contributions paid to your State unemployment fund . 

B Are you required to pay contributions to only one State? 

. D Yes 0 No 

..... $ I ------------.- -cf v~~ -tj-N~-

If you checked the "Yes" box, (1) Enter the name of the State where you are required to pay contributions . ..., ____________________________ _ 

(2) Enter your State reporting number(s) as shown on State unemployment tax return . . ..., 

PART 1.-Computatlon of Taxable Wages and Credit Reduction (To Be Completed by All Taxpayers) 

1 Total payments (including exempt payments) during the calendar year for services of employees 1 I I 

2 ~=~:~;)a;~~~t~~ -~~~~~i~- -~a_c_h_ -~x-e-~~~i~~ -~~~~-n~ -~~~~~~~ -~~~i:~o_n_a~ _ :~~~~s- -i~ f f~~~Am~ou~n~t p~a~id~~~llllllllllil 3 Payments-for services iri-excess -;f-$7 ~666.- E:iiter- oniy- ftie excess over thP. -fir.st -si.ooo 

Ga1d to individual employees exclusive of exempt amounts entered on line 2. Do not use 3 tate wage limitation . . . . . . . . . . . . . . . . . . . . 

4 Total exempt payments (add lines 2 and 3) 4 I I 

5 Total taxable wages (subtract line 4 from line 1). (If any portion is exempt from State contributions, see instructions)"" ....._5;;__,__l ________ __ll __ 

6 Credit reduction for unrepaid advances to the States listed. Enter the wages included on line 5 above for each State and multiply by the rate shown. 

(1) AR _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ (&) Ml _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ (m) VT _____________ x .006 ____________ _ 

(b) CT _____________ x JXJ7 _ _ _ _ _ _ _ _ _ _ _ _ _ (h) MN _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ (n) WV _____________ x .006 ____________ _ 

(c) DE _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ (I) NJ _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ Outside the U.S. 

(d) DC _____________ x .011 _ _ _ _ _ _ _ _ _ _ _ _ _ G> OH _____________ x .006 _ _ _ _ _ _ _ _ _ _ _ _ _ (o) PR _____________ x .006 ____________ _ 

(1) IL _____________ x J1J7 _ _ _ _ _ _ _ _ _ _ _ _ _ (k) PA _____________ x .007 _ _ _ _ _ _ _ _ _ _ _ _ _ (p) VI _____________ x .006 ____________ _ 

(f) KY ____________ .x .003 _ _ _ _ _ _ _ _ _ _ _ _ _ (I) RI _____________ x .006 ____________ _ 

7 Total credit reduction (add lines 6(a) through G(p) and enter on line 2, Part II or line 4, Part 111) . 

PART 11.-Tax Due or Refund {Complete If You Checked the "Yes" Boxes In Both Items A and B Above) 

1 FUTA tax. Multiply the wages on line 5, Part I, by .008 and enter here 1 

2 Enter amount from line 7, Part I 2 

3 Total FUTA tax (add lines 1 and 2) 3 

4 Less: Total FUTA tax deposited for the year from your records 4 

5 Balance due (subtract line 4 from line 3-if over $100, see Part IV instructions). Pa0

o IRS . . .... 5 

6 Overnavment (subtract line 3 from line 4). Check if to be: D Applied to next return, or Refunded ..... 6 

PART 111.-Tax Due or Refund (Complete If You Checked the "No" Box In Either Item A or Item B Above. Also complete Part V) 

1 Gross FUTA tax. Multiply the wages on line 5, Part I, by .035 1 

2 Maximum credit. Multiply the wages on line 5, Part I, by .027. 1· 2 I 

3 Enter the smaller of the amount on line 11, Part V, or line 2, Part Ill . 13 

4 Enter amount from line 7, Part I 4 

5 Credit allowable (subtract line 4 from line 3) 5 

6 Total FUTA tax (subtract line 5 from line 1) . 6 

7 Less: Total FUTA tax deposited for the year from your records 7 

8 Balance due (subtract line 7 from line 6-if over $100, see Part IV instructions). Pay to IRS . . . .... 8 

g Overnavment (subtract line 6 from line 7).Check if to be: D Aoolied to next return or 0 Refunded ..... 9 

PART IV.-Record of Quarterly Federal Tax Liability for Unemployment Tax 1 Do not include State liabilitr) 

Quarter I First I Second I Third Fourth Total for Year 

Liability for quarter . I I . I 

If you wlll not have to flle returns In the future, write "Flnal" here (see general Instruction "Who Must Fiie") .... Under penalties of periury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, 1t 1s true, correct and 

complete, and that no part of any payment made to a State unemployment fund claimed as a credit was or is to be deducted from the payments to employees. ' 

Date ... Signature .... Title (Owner, etc) .... 

Form 940 (1983) 
Form 940 (1983) 

PART V.-Computatlon of Tentative Credit (Complete if You ChKktd the 11No" Box in Either Question A or Bon Page 1-See Instructions) 

Name State reporting number(s) Taxable payroll State ex- Contributions if 

of as shown on employer's State experience rate period perience rate had been 2.796 

State State cont. ibution returns (as defined in State act) 4 rate (COL 3 x 2.796) 

1 2 3 From- To- 5 6 

10 Totals ..... 11 Total tentative credit (add line 10, columns 8 and 9-see instructions for limitations) 

Hlghllghts 

Changes for 1983.-Public Law 97-248 

increased the wage base to $7 ,000 and increased 

the tax rate to 3.596 for 1983 and 1984. 

For deposit purposes, multiply by .008 that 

part of the first $7 ,000 of each employee's 

annual wages that you paid during the quarter. 

Follow the deposit rules in Part IV on page 4. 

Special assessments (surcharges, surtaxes.etc.) by a State to pay the interest on Title 

XII loans to a State from the Federal government are not includible as Mcontributions." 

Contact your State unemployment agency if 

you are not sure whether your payments to the 

fund include these charges. 

1. Household Employers: You do not have to 

file this form unless you paid cash wages of 

$1,000 or more for household work in any 

calendar quarter in 1982 or 1983. 

2. Household and Other Employers Who Fiie 

Form 940: If your total Federal unemployment 

(FUTA) tax for 1983 is not more than $100, you 

do not have to deposit the tax. If you do not have 

to deposit FUTA tax and you: 

(a) made all required payments to your State 

unemployment fund, 

(b) are required to make payments to the 

unemployment fund of only one State, and 

(c) paid wages subject to Federal 

unemployment tax that are also subject to 

State unemployment tax, 

complete Parts I and II. Otherwise, complete 

Parts I, Ill, and V. 

3. Employers Who Are Required to Deposit 

FUTA Tax: If you meet tests (a), (b), and (c) 

above, complete Parts I, II, and IV. Otherwise, 

complete Parts I, Ill, IV, and V. 

General Instructions 

Paperwork Reduction Act Notlce.-We ask 

for this information to carry out the Internal 

Revenue laws of the United States. We need it to ensure that taxpayers are complying with these 

laws and to allow us to figure and collect the right 

amount of tax. You are required to give us this 

information. 

Purpose of Form.-Use it for the annual 

reporting of tax under FUTA. This tax Is paid only 

by the employer. The gross tax rate is 3.5% 

(.035) on the first $7 ,000 of wages paid to each 

employee during 1983. 

Who Must Flle.-ln general, every employer 

who during 1982 or 1983 (a) paid wages of 

$1,500 or more in any calendar quarter or (b) had 

one or more employees for some part of a day in 

any 20 different weeks must file. Count all 

regular, temporary, and part-time employees. A 

partnership should not count its partners. If there 

is a change in ownership or other transfer of 

business during the year, each employer who 

meets tests (a) or (b) above must file. Neither 

should report wages paid by the other. 

Organizations described in Code section 

50l(c)(3) do not have to file. 

As an agricultural or household employer, you 

must file Form 940 if any of the following apply to 

you: 

(1) You paid cash wages of $20,000 or more to farmworkers during any calendar quarter in 

1982 or 1983. 

(2) You employed 10 or more farmworkers 

during some part of a day (whether or not at the 

same time) for at least one day during any 20 

different weeks in 1982 or 1983. Count aliens 

admitted to the U.S. on a temporary basis to 

perform farmwork to determine if you meet either 

of the above tests. However, wages paid to these 

aliens are not subject to FUTA tax prior to 1986. 

(3) You paid cash wages of $1,000 or more in 

any calendar quarter in 1982 or 1983 for 

household work in a private home, local college 

club, or a local chapter of a college fraternity or 

sorority. Note: See Form 942 for a definition of 

household work in a private home. 

If you receive Form 940 and are not liable for 

Federal unemployment tax for 1983, write "Not 

Liable" across the front and return it to IRS. If you 

will not have to file returns after this, write 

"Final" on the line above the signature line. 

Due Date.-Form 940 for 1983 is due by 

January 31, 1984. However, if you made timely 

deposits in full payment of the tax due, your due 

date is February 10, 1984. 

Where to Fiie.-

H 1our prlnd1t9I 

bullnem, otftce, or a1ency It loalted In 

... New Jersey, New York City and counties of N1ssau, Rockland, Suffolk and Westchester 

New York (all other counties), 

Connecticut, fJ.3ine, 

Massachusetts, New Hampshire, Rhode Island, Vermont 

Delaware, Oistrict of Columbia, 

Maryland, Pennsylvania 

Alablllll, Florida, Georaia, 

Mississippi, South C.rolina 

Michipn,Ohio 

Arkansas, KallSls, Louisiana, New Mexico, Oklahoma, Texas 

Alaska, Arizool, Colofado, Idaho, Minnesota, Montana, 

Nebraska, Nevad1, North Oakota, 

Oregon, South Dakota, Utah, 

Washinaton. ~ing 

Illinois, Iowa, 

Missouri, Wisconsin 

Cllifomia, Hawaii 

Indiana, Kentucky, North Carolina, Tennessee, 

Virginia, West Virginia 

Fiie with the lntamal Revenue Service 

Canter at 

... 

Holtsville, NY 00501 

Andover, MA 05501 

Philadelphia, PA 19255 

Atlanta, GA 31101 

Cincinnati, OH 45999 

Austin, TX 73301 

Ogden, UT 84201 

Kansas City, MO 64999 

Fresno, CA 93888 

Memphis, TN 37501 

If you have no legal residence or principal place of 

business in a:iy IRS district, or if your principal place of 

business is in Puerto Rico or the U.S. Virgin Islands, file 

Form 940 with the Internal Revenue Service Center, Philadelphia, PA 19255. 

Employer's Name, Address, and 

Identification Number.-Use the preaddressed 

Form 940 mailed to you. If you must use a nonaddressed form, type or print your name, 

trade name, address, and employer identification 

number on it. 

Contributions Additional credit Contributions 

payable at experience (col. 6minuscol.7) actually paid to 

rate (col. 3 x col. 5) lfOorless,enterO. State 

7 8 9 

.... I 

See Publlcatlon 583, Information for Business 

Taxpayers, for details on how to make tax 

deposits, file a return, etc., if these are due before 

you receive your number. 

Penalties and lnterest.-Avoid penalties and 

interest by making tax deposits when due and 

filing a correct return and paying the proper 

amount of tax when due. The law provides 

penalties for late deposits and late filing unless 

you show reasonable c;ause for the delay. If you 

are late, attach an explanation to the return. The 

law also provides a penalty of 25% of the 

overstatement if, without reasonable cause, you 

overstate the amount you deposited. 

There are also penalties for willful failure to 

pay tax, keep records, make returns, and for filing 

false or fraudulent returns. 

Credit for Contributions Paid Into State 

Funds.-You can claim credit for amounts you 

pay into a certified State (including Puerto Rico 

and the U.S. Virgin Islands) unemployment fund 

by the due date of Form 940. 

"Contributions" are payments that State law 

requires you to make to an unemployment fund 

because you are an employer. These payments are ''contributions" only to the extent that they 

are not deducted or deductible from the 

employees' pay. 

You may not take credit for voluntary 

payments or for penalties or interest payments to a State. Nor may you take credit for any special 

assessment, surtax, surcharge, etc. by the State 

for paying interest on unrepaid Title XII loans from 

the Federal government. 

If you have been granted an experience rate 

lower than 2. 796 (.027) by a State for the whole or 

part of the year, you are entitled to an additional 

credit. This credit is equal to the difference 

between actual payments and the amount you 

would have been required to pay at 2.796. 

The total credit allowable may not be more 

than 2. 7% of taxable FUTA wages. 

Speclal Credit for Successor Employers.-lf 

you are claiming special credit as a successor employer, see Code section 3302(e) or Circular E 

for the conditions that you must meet. 

Specific Instructions 

All filers must complete Questions A, B, and Part I and 

must sign the return. 

Use Part II if you pay contributions to only one State 

unemployment fund, you made all ~tate payments by the due 

date of Form 940, and all of the FUTA waaes are subject to 

the State's unemployment fund taxes. Otherwise, skip Part II 

and complete Parts Ill and V. 

Complete Part IV if your total tax for the year is more 

than $100. 

Part 1.-Computatlon of Taxable Wages 

and Credit Reduction 

Line 1-Total payments.-Enter the total 

payments you made to employees during the 

calendar year, even if they are not taxable. 

Include salaries, wages, commissions, fees, 

bonuses, vacation allowances, amounts paid 

(Instructions continued on page 4.) 
Form 940 (1983) 

PART V.-Computation of Tentative Credit (Complete if You Checked the "No" Box in Either Question A or Bon Page 1-See Instructions) 

Name State reporting number(s) Taxable payroll State ex- Contributions if of as shown on employer's (as defined in State act) State experience rate period perience rate had been 2 .7% State State contribution returns 4 rate (col.3x2.7%) 

1 2 3 From- To- 5 6 

10 Totals .... 

11 Total tentative credit (add line 10, columns 8 and 9-see instructions for limitations) 

to temporary or part-time employees, and the 

value of goods, lodging, food, and clothing. Enter 

the amount before any deductions. 

How the payments are made is not important 

in determining if they are wages. Thus, you may 

pay wages for piecework or as a percentage of 

profits, and you may pay wages hourly, daily, 

weekly, monthly, or yearly. You may pay wages in 

cash or some other way, such as goods, lodging, 

food, or clothing. For items other than cash, use 

the fair market value at the time of payment. 

Line 2-Exempt payments.-"Wages" and 

"employment" as defined for FUTA purposes do 

not include every payment and every kind of 

service an employee may perform. In general, 

payments excluded from wages and payments for 

services excepted from employment are not 

subject to tax. You may deduct these payments 

from total payments only if you explain them on 

line 2. 

Enter such items as the following: 

(1) Agricultural labor if you (a) did not pay 

cash wages of $20,000 or more for such labor for 

any calendar quarter in 1982 and 1983 AND did 

not employ 10 or more farmworkers during any 

part of a day during any 20 different weeks in 

1982 or 1983, (b) paid wages to aliens admitted 

to the United States on a temporary basis to 

perform farmwork before 1986. 

(2) Benefit payments for sickness or injury 

under a worker's compensation law, insurance 

plan, and certain employer plans. 

(3) Household service if you did not pay 

cash, wages of $1,000 or more in any calendar 

quarter in 1982 and 1983. 

(4) Certain family employment. 

(5) Certain fishing activities. 

(6) Noncash payments for farmwork or 

household services in a private home that are 

included on line 1. Only cash wages to these 

workers are taxable. 

(7) Value of certain meals and lodging. 

(8) Any other exempt service or pay. 

For more detailed information, see Circular E, 

Employer's Tax Guide. 

Line 3.-Enter the total of the amounts you 

paid each employee in excess of $7 ,000. For 

example, if you have 10 employees whom you 

paid $8,000 each during the year, enter $80,000 

on line 1 and $10,000 on line 3. The $7,000 

wage limitation is for FUTA purposes only. Do not 

use the State wage limitation for this entry. 

Line 5-Total taxable wages.-lf any part of 

these wages is exempt from State unemployment 

taxes, you must fill out Parts Ill and V, even if you 

checked questions A and B "Yes." 

Line 6.-Enter any wages included on line 5 

subject to the unemployment compensation laws 

of the states listed. (If in doubt, ask your local IRS 

office.) Multiply the wages by the appropriate 

rate. This adjustment is required by Internal 

Revenue Code section 3302(c)(2). If no wages 

are subject, enter "none" on line 7. 

Part 11.-Tax Due or Refund 

Use this part if you made payments to only one State by 

the due date of Form 940, and all your wages shown on line 5 

of Part I are subject to the State's unemployment fund taxes. 

The tax rate of .008 gives you credit for your payments to 

your State's unemployment fund. 

Part 111.-Tax Due or Refund 

Use this part if you do not qualify for Part II. 

Line 3.-Enter the smalier of (1) line 11, Part 

V-Total tentative credit, or (2) line 2, Part 

111-2. 7% of taxable FUTA wages. This is the 

maximum credit allowable for your payments to 

the State unemployment fund . 

Line 4.-Enter the amount from line 7, Part I. 

Subtract this amount from line 3, Part Ill. The 

result on line 5 is your allowable credit for 

payments to the State. 

Part IV.-Record of Federal Tax Liability 

Complete this part if your total tax (line 3, Part 

II or line 6, Part Ill) is over $100. To figure your 

FUTA tax liability for each of the first 3 quarters 

of 1983, multiply by .008 that part of the first 

$7 ,000 of each emplqyee's annual wages you 

paid during the quarter. Enter this amount under 

that quarter. 

Your liability for the 4th quarter is the total 

tax (line 3, Part II or line 6, Part Ill) minus your 

liability for the first 3 quarters of the year. If 

this plus any undeposited amount from earlier 

quarters is over $100, deposit the entire amount 

by January 31 in a qualified depositary. If it is 

$100 or less, you car. either make a deposit or 

pay it with your Form 940 by January 31 . 

The total liability must equal your total tax. 

Otherwise, you may be assessed a failure to 

deposit penalty computed on your average 

liability. 

If the amount subject to deposit (plus any 

undeposited amount of $100 or less for any 

earlier quarter) is more than $100, deposit it by 

the last day of the first month following the close 

of the quarter. 

If you deposited the proper amounts, following 

these rules, the balance due with Form 940 will 

never be more than $100. 

Deposit Federal unemployment tax in an 

authorized financial institution or the Federal 

Reserve bank for your area. To avoid a possible 

penalty, do not mail deposits directly to IRS. 

Records of your deposits will be sent to IRS for 

crediting to your business accounts. 

Beginning January 1, 1984, new coupon 

forms will be used for depositing taxes. In . 

December 1983, IRS will send you a Federal 

Tax Deposit Coupon Book (Form 8109) containing 15 coupons for depositing all types of 

Contributions Additional credit Contributions 

payable at experience (col. 6minuscol.7) actually paid to rate (col. 3 x col. 5) If 0 or less, enter 0. State 

7 8 9 

.... I 

taxes. Indicate the type of tax on the coupon 

(940 in this case) and include a coupon with 

each deposit you make. 

Taxpayers who willfully claim credit for 

deposits not made are subject to fines and other 

criminal penalties. 

Part V.-Computation of Tentative 

Credit 

Complete this schedule if: (1) You made payments to the 

unemployment fund of more than one State; (2) You did not 

make your State payments by the due date of Form 940; or 

(3) Any wages subject to Federal unemployment tax were 

exempted from State unemployment taxes. If you have a 

State experience rate lower than 2.7% for all or part of the 

year, use columns I through 9. If you have no experience 

rate, use columns 1, 2, 3, and 9 only. If you have a rate of 

2.7% or higher, use columns I 2, 3. 4, 5, and 9 only. If you 

were granted an experience rate tor only part of the year or 

the rate was changed during the year, enter in the 

appropriate columns the period each separate rate applied to, 

your payroll rate, 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) that you were required to pay 

contributions to. 

Column 2.-Enter the State reporting 

number that was assigned to you when you 

registered as an employer with each State. 

Column 3.-Enter the taxable payroll on 

which you must pay taxes to the unemployment 

fund of each State in column 1. If your experience 

rate is zero, enter the amount of wages that you 

would have had to pay on if the rate had not been 

granted. 

Columns 4 and 5.-Your State experience 

rate is the rate at which the State taxes your 

payroll for State unemployment purposes. This 

rate may be adjusted from time to time based on 

your "experience" with the State fund, that is, 

unemployment compensation paid to your former 

employees and other factors . If you do not know 

your rate, contact your State unemployment 

security agency. 

Column 8.-Subtract the amount in column 7 

from column 6. If zero or less, enter " O." 

Column 9.-Enter the amount of 

contributions actually paid into the State fund. Do 

not include any special assessments, surtaxes, 

surcharges, etc., used by the State to pay interest 

on unrepaid advances from the Federal 

government. 

Line 11.-Add the total of line 10, columns 8 

and 9. The allowable credit for State contributions 

you make after the due date (or extended due 

date) for filing Form 940 may not be more than 

90% of the credit that would have been allowed if 

you had paid the State contributions by the due 

date. 
ACKNOWLEDGEMENTS 

This report was prepared by Jenny Wahl and Harry Grubert of the Office of Tax Analysis 

and Peter Barnes of the International Tax Counsel staff, under the direction of Daniel 

Frisch of the Office of Tax Analysis and Mary Bennett of the International Tax Counsel 

staff. Gordon Wilson of the Office of Tax Analysis provided statistical support, and typing 

assistance was provided by Elsa Montoya. 

U. 5. GOVERNMENT PRINTING OFFICE 1989/242-752/07309 
Department ~f the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300