(c) Upon a surtax net income over $50,000, but not over $75,000, $1,250, plus 10 percent of the amount of the surtax net income over $50,000.

(d) Upon a surtax net income over $75,000, but not over $100,000, $3,750, plus 15 percent of the amount of the surtax net income over $75,000.

(e) Upon a surtax net income over $100,000, $7,500, plus 20 percent of the amount of the surtax net income over $100,000. "Surtax net income" means normal tax net income minus the following credits:

(A) The amount of the normal tax.

(B) Five percent of the normal tax net income.

(c) An additional tax of 5 percent of the sum of the normal and

surtax.

Mr. LOCKLIN. How many brackets do you have in that graduated surtax?

Mr. VÉLEZ. Five.

Mr. LOCKLIN. I would like to point out that this committee, from time to time, has gone on record in favor of graduated income tax for corporations in order to aid small business. And I think you are to be complimented that your rate structures are set up that way, because I am sure this is of considerable benefit and assistance to small business.

Mr. VÉLEZ. Thank you, sir.

Foreign corporations or partnerships doing business in Puerto Rico are taxed here at the same rates applicable to domestic corporations, and their gross income includes only the gross income from sources within this country. In other words, they are not required to report income from sources outside Puerto Rico. Deductions are allowed only if and to the extent that they are connected with income from sources within this Commonwealth.

Foreign corporations or partnerships not engaged in trade or business in this Commonwealth are taxed here at a flat rate of 29 percent upon fixed or determinable gains as, for example, interest, dividends, and rents. However, if the dividends are paid by a domestic corporation engaged in the manufacturing or hotel business in Puerto Rico, this flat rate is lowered to 15 percent.

I have already submitted to you, in my letter of April 1, 1964, some additional information on the Puerto Rican tax structure which I think would be apropos at this point.

Senator BARTLETT. It will be put in the record at this point.

(The information on the Puerto Rican tax structure was subsequently received, and follows:)

EXHIBIT 62

APRIL 1, 1964.

In connection with further questions proposed by the committee, let us inform you that the term "foreign" (when applied to corporations in the general corporations law of Puerto Rico, or when applied to corporations and partnerships in any section of the Income Tax Act of 1954) means a corporation or a partnership, whatever the case be, not created or organized in Puerto Rico under the laws of the Commonwealth of Puerto Rico. Thus, the term "foreign" does not apply to a subsidiary organized as a Puerto Rican corporation pursuant to the general corporations law of Puerto Rico, even if such subsidiary is wholly owned by a U.S. corporation.

For purposes of income taxation, foreign corporations or partnerships are divided into two classes: foreign corporations not engaged in trade or business within Puerto Rico (known as nonresident foreign corporations), and foreign corporations engaged in trade or business within Puerto Rico (known as resident foreign corporations). Nonresident foreign corporations are taxed here at the rate of 29 percent (with the exception noted below) upon their fixed or determinable annual or periodical income and capital gains, to the extent such income and gains are derived from sources within Puerto Rico. Resident foreign corporations are taxed on their income from sources within Puerto Rico at the rates applicable to domestic corporations, after allowable deductions and credits.

Since reference has been made in your letter to act No. 49 of June 13, 1961, let me point out that provisions similar to those contained therein were made applicable to domestic corporations under act No. 37 of June 13, 1962. Accordingly, a Puerto Rican corporation (whether or not a subsidiary of a U.S. corporation) doing business without this country is also required to maintain accounting materials in Puerto Rico.

Dividends and partnership profits received by nonresident foreign corporations or partnerships from corporations or partnerships engaged in the manufacturing or hotel business within Puerto Rico, are taxed at a rate of 15 percent, in lieu of the general statutory rate of 29 percent, when such dividends or profits are derived solely from such manufacturing or hotel activities. This tax reduction (which applies with respect to taxable years beginning on or after July 1, 1961) is mainly designed to promote the establishment of new hotel and manufacturing enterprises in Puerto Rico by foreign corporations, and to avoid the impairment of our industrial tax exemption program which might otherwise result from the imposition of a high tax burden on distributions received by nonresident corporate stockholders controlling locally exempt industries. Under sections (a), (b), and (c) of the Industrial Incentives Act of 1963, corporate businesses (whether or not organized under the laws of Puerto Rico) qualifying for exemption thereunder are exempt from the payment of income taxes (but only upon income derived from activities which gave rise to the exemption), municipal or Commonwealth taxes on real and personal property used in the operation of the exempted activities, and license fees, excises, or other municipal taxes levied by a municipality. Under the Excise Tax Act of Puerto Rico, as amended by act No. 36 of May 31, 1963, an exempt business is also relieved from the payment of Commonwealth excise taxes on plant property used directly in manufacturing activities which gave rise to the exemption.

Section 3 of the Industrial Incentives Act of 1963 acts to relieve individual and corporate stockholders from the payment of taxes on distributions received from locally exempt businesses, but only under certain circumstances. For example, corporate and individual shareholders on the mainland owning shares of stock in an exempt business (whether it be a domestic or a foreign corporation) might not avail themselves of the exemption upon such distributions if they were required to report such amounts as taxable income in an income tax return filed with any taxing jurisdiction other than Puerto Rico. This tax relief granted to distributees when qualifying therefor, is available, as a general rule, for the same number of years during which the distributor business enjoys industrial tax exemption. Thus, the exemption period for distributions, which usually covers 10 years, may extend for a longer period such as the 17year period provided under section 1(j) (4) of the 1963 Industrial Incentives Act when the exempt business is established in an underdeveloped area prior to December 31, 1966.

In the table appearing on page 21 of the 1962 Treasury Department Report, whch shows estimated taxes that would have been collected from tax-exempt corporations, only income taxes have been taken under consideration. The corporate rates used as a basis for the computation are those prescribed under sections 13, 15, and 406 of the Income Tax Act of 1954, relative to the imposition of a normal tax of 20 percent, a surtax at progressive rates on surtax net income, and an additional tax of 5 percent computed on the sum of the normal tax and surtax, respectively.

(Signed) RAMÓN H. VÉLEZ, Under Secretary of the Treasury.

4. Problems leading to TIR 441

Mr. VÉLEZ. In the early part of 1959 it came to the attention of the Commonwealth that in several cases regional offices of the Internal Revenue Service were investigating the question of proper intercompany transfer prices between factories operating in Puerto Rico and affiliated distributors and contractors in the United States.

In view of this, it was deemed necessary that some of our officials confer with the proper officials of the U.S. Treasury, not only because of the adverse implications of such practices on the development of our industrialization program, but because of its fiscal impact, since many exemptions were beginning to expire, and thus, previously exempt income would become taxable in Puerto Rico.

If the Federal Internal Revenue Service should tax profits which derived from, and are within the tax jurisdiction of the Commonwealth, then the Commonwealth's treasury department would be faced with a difficult choice. It would either be forced to forgo the taxation of profits viewed by it as legitimately earned within its jurisdiction, or subject those profits to a second tax, with serious consequences to the industrialization program.

As a result of the many conferences held in order to cope with the above problems, TIR 441 was issued.

5. Evaluation of TIR 441

We have not, as of now, sufficient elements of judgment in order to evaluate TIR 441. That is something that the IRS is in a better position to do than us, because of the short time that has elapsed since its issuance, which was in the beginning of 1962, or rather, 1963. 6. Patterns of distributions, transfers, liquidations, et cetera

Enterprises operating in Puerto Rico under the exemption program adopt different patterns of organization. The most common forms

are:

(1) The creation of a domestic corporation whose stock may be owned by resident or nonresident individuals or by resident or nonresident corporations;

(2) The creation of a foreign corporation, qualified to do business in Puerto Rico, whose stock may be owned by nonresident personsand I should add, it could be also by resident persons-including foreign corporations; and

(3) The qualification of a corporation to do business in Puerto Rico by means of a branch or division.

Dividends distributed by such exempt enterprises are exempt from income tax, if paid to resident persons or to nonresident persons who are not required to report such income to any taxing jurisdiction outside Puerto Rico.

Exempt enterprises may distribute their earnings currently or may postpone distributions until liquidation. They are permitted to liquidate tax free into their parent organization during or after the expiration of the exemption period, thus removing from this jurisdiction the invested capital plus the earnings accumulated during the period of exemption.

We have not observed any pattern of distribution different from that followed by taxable enterprises.

7. Current problems and solutions

(a) Accounts receivable, loans, advances.-Some enterprises enter into our jurisdiction showing a low level of capitalization, and a high level of liabilities in the form of accounts payable, loans, and advances. This situation may arise from valid business purposes, but it also may constitute a scheme to treat remittances abroad as refund of capital rather than as taxable dividends. Anyway, these situations are closely watched, and decided according to the facts present in each such situation.

Here I may add that I got curious when I was writing this paper, and I glanced through about a hundred returns-I mean the balancesheet section of about a hundred returns. And I could not tell from that quick examination that there is any abuse in this particular item.

(b) Withholding.-Withholding upon dividends is mandatory under our law. Except in cases in which the question arises as to whether the distribution made is properly a dividend, we are not faced with any problem at all. Withholding upon wages, et cetera, is currently being made.

(c) Accounting methods.-No special policies are followed in connection with accounting methods, other than the exempt activities must be separated from taxable activities in the books of the exempt enterprise. Anyway, it is required that income be clearly reflected both in the books and in the returns that are filed.

(d) Intercompany pricing, standards to be used. As it was already pointed out, this is a matter primarily of fact. However, in general terms, intercompany prices must be established on the same basis as independent persons, having adverse interests, would do it.

(e) Allocation.-This is a topic which pervades this whole situation. As we have already set forth, careful consideration of the facts may disclose if a particular item allocated to an enterprise really corresponds to another enterprise. When there is certainty as to this, the reallocation must be made. Access to the books of all related parties is required to arrive at a decision on this issue of reallocation.

(f) Multiple corporation structure. Our approach against tax avoidance through the multiple corporation setup is the same as that used by the Internal Revenue Service. However, we are lacking certain provisions of the Federal statute which have not been incorporated into our law.

Mr. LOCKLIN. Mr. Chairman, may I ask something with reference to the multiple corporations?

Senator BARTLETT. You may.

Mr. LOCKLIN. This graduated surtax that you mentioned-where you have a group of affiliated corporations, is their income tax-is the separate corporate entity recognized in the application of your graduated surtax, or is the income considered in a lump, and thereby subject to the higher rate?

Mr. VÉLEZ. No; it is recognized. We do not have consolidated

returns.

Mr. LOCKLIN. Each of the separate corporations is taxed at the rate applicable to itself, regardless of the degree of affiliation?

Mr. VÉLEZ. That is correct. Although in one case we questioned that setup-we found valid reason for it to be so, and allowed itI know only of one case. They had valid reasons.

I would like to add here that our Income Tax Act of 1954 follows the pattern of the 1939 act of the United States. That is the main reason why we do not have some of the provisions dealing with the corporate structure. We have not seen, thus far, the need to incorporate them. But as soon as we see the need, we shall proceed to incorporate them.

Mr. LOCKLIN. We have an exemption from the surtax for small corporations under the 1954 code.

The reason I was interested in that area is that our committee has been in favor of not allowing that exemption on a multiple basis for affiliated corporations.

Mr. VÉLEZ. Well, I am a collector of taxes and in that case I am with you, too. But we found valid business reasons and we allowed it. Being a collector, I am 100 percent in agreement with you.

(g) Liquidations.-Liquidation of exempt enterprises follows, generally, the same pattern as that of taxable entities, with the exception noted under paragraph 6. Resident individuals, and nonresident individuals who have not to pay in other jurisdiction a tax on their income from Puerto Rican sources, are permitted to receive tax free the accumulated earnings of an exempt enterprise upon liquidation. (h) Reinvestment of earnings.-There are neither specific problems, nor special patterns followed, in connection with the reinvestment of earnings.

I may say we have one case, a big concern, that is reinvesting of earnings. But it is just one case and not typical.

(i) Intangibles.-Problems of allocation may arise in this area which have to be solved, as we have pointed out under paragraphs 4 and 5, above.

up

DEVELOPMENT OF THE FINANCIAL COMMUNITY

(a) Securities.-I want to be very brief on this.

We had no legislation in connection with the securities market, until June 18, 1963. And that law went into effect on December 18, 1963. So we have little information to supply, except that as of today we have registered under the act a total of 18 mutual funds, selling an aggregate amount of close to $15 million in shares.

There is also one industrial corporation who has registered $600,000 worth of its shares for sale to the public. There are at least five different offerings being sold without registration because they are enjoying a 1-year exemption as provided by section 418 of the act.

Furthermore, we have registered close to 200 agents, and 19 brokerdealers, to do business in Puerto Rico. Three of those broker-dealers are members of the New York Stock Exchange.