Section 936 of the Internal Revenue Code was a measure by the U.S. federal government to encourage U.S. corporations to invest in Puerto Rico by providing an exemption from federal taxes. The measure promoted the banking and finance industries, as well as manufacturing, mainly pharmaceutical and electronics companies.
Section 936 replaced the previous Section 931, which was in place from the 1920s on and allowed U.S. corporations not to pay taxes on their overseas operations until they repatriated their earnings to the United States. Section 931 was in effect until the middle 1970s when a series of changes in international economic policy affected U.S. interests.
In the 1970s, the U.S. economy began to experience a period of stagnation due to its commitments to international alliances and the pressure from the welfare state on the local economy and, in particular, federal revenues. Additionally, the wars in the Middle East caused an increase in the price of oil, which contributed to the economic recession. This forced the United States to end the gold standard for the dollar, allowing its currency to fluctuate for the first time since the end of World War II, making their exports less expensive and more competitive.
This process of stagflation, as economists of the era called it, would impact relations between the United States and Puerto Rico. Puerto Rico suffered the consequences of the world recession, the malaise of the U.S. economy, and the high price of imported oil. The negative effects of the crisis caused a huge increase in unemployment and the end of the Puerto Rican model of exporting to the United States, based on cheap local labor. The resulting social and structural crisis suffered by the island economy put pressure on federal aid programs such as the Food Stamps Program and other federal measures to alleviate unemployment, which increased the Puerto Rican economic dependence on Washington.
To spur the Puerto Rican economy and reduce dependence on federal funds, Congress amended the Internal Revenue Code and created Section 936 in 1976. Its purpose was to allow subsidiaries of U.S. corporations to establish operations on the island and repatriate their profits to the parent company without paying federal taxes. Unlike the former Section 931, which allowed the subsidiaries’ earnings to be repatriated tax-free only when the assets were eliminated, Section 936 allowed repatriation of profits as soon as they were realized. This created an incentive for these corporations to keep their earnings within the U.S. economy and not in European banks to avoid paying federal taxes.
The government of Puerto Rico sought to go beyond the limits of the model of exporting to the United States (a model that had been exhausted) and make the island a financial center that would offer fiscal benefits that would attract transnational corporations that could attribute a high percentage of their profits to local subsidiaries. Economist James Dietz explained that the local government wanted the earnings of the Section 936 corporations to contribute to the economy of Puerto Rico, not only through the creation of jobs in their subsidiaries, but also to the island’s treasury. To do this, a tollgate tax of 10% on earnings was imposed. The government also offered the option of paying a lower tax of 5% if the companies bought Commonwealth bonds, public corporation bonds or deposited the funds in local banks.
According to historian Francisco Scarano, thanks to Section 936, Puerto Rico became the top choice in the world for investment by U.S. corporations. Section 936 also promoted the growth of the banking industry on the island. The economic incentives created by Section 936 led to a massive inflow of U.S. and Spanish capital. Banking in Puerto Rico was denationalized and new financial entities, such as Chase, Citibank and Santander, entered and dominated the financial scene. The local banks that survived were consolidated in a merger between Banco Popular and Banco de Ponce.
It was debatable, however, whether Section 936 produced the expected benefits and the corporations’ huge profits, being exempt from federal taxes, became funds deposited on the island but were subtracted from federal revenues. As a result, Section 936 underwent several revisions by Congress during its twenty years of existence.
Initially, in 1982, under the Ronald Reagan administration, Congress tried to control the Section 936 earnings and passed legislation that intended to limit U.S. corporations investing their profits in Puerto Rico and then later repatriating them without paying federal taxes. In 1985, the Treasury Department proposed the elimination or modification of Section 936 to collect the estimated $7 billion in revenues that were being lost. The modifications allowed the Section 936 funds to have a regional effect by permitting them to be reinvested in the countries participating in the Caribbean Basin Initiative.
In 1993, facing a budget deficit in the United States, President Bill Clinton reexamined Section 936 and recommended its elimination. The same year, legislation was passed that limited the tax credit corporations could assign to their manufacturing production in Puerto Rico. Finally, Section 936 was eliminated in August of 1996, with a 10-year grace period for companies that remained in Puerto Rico. The new law, Section 30A, remained until 2005.
Another criticism of Section 936 focused on its ability to generate jobs in Puerto Rico. Critics of the Section 936 companies argued that they only defended their tax benefits but did not support local development of research and high technology. It is estimated that between 1982 and 1989 the pharmaceutical industry saved $73 million to $79 million per year in taxes while it employed just 3,000 people. Despite the measure’s intention of reducing unemployment, the jobless rate and federal aid both actually increased. Even U.S. economists called Section 936 a tax dodge to avoid paying federal taxes.
During its existence, Section 936 was supported by both dominant political parties in Puerto Rico. This changed with the administration of Pedro Rosselló of the New Progressive Party (1993–2000), who withdrew his support for Section 936 as its elimination appeared inevitable. According to some analysts, the post-936 era shows an increasing loss of manufacturing jobs on the island, a trend in place since 1997. The Rosselló administration admitted the decrease in manufacturing jobs but refused to blame it on the end of Section 936 and said that the island’s economic growth would continue, thanks to the services sector and construction.
Section 936 was replaced by Section 901 of the Internal Revenue Code, which regulated U.S. corporations outside the United States. So the corporations that remained on the island and formerly operated under Section 936 now function under Section 901 and are classified as foreign corporations.
The North American Free Trade Agreement between Mexico, Canada and the United States was seen as a sign that Section 936 was no longer viable. Because of these free trade agreements with the rest of the western hemisphere, Puerto Rico’s advantage as a territory of the United States was lost in the post-Cold War world.
Author: José Gabriel Martínez Borrás
Published: September 15, 2014.
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