Walmart and Puerto Rico

By: David J. Herzig

Everyone knows by now the dire financial problems facing Puerto Rico.  (My co-blogger Shu-Yi Oei wrote about the default in Surly here.)  In order to generate liquidity to pay debt and run government operations, Puerto Rico began to look to the deepest pockets for help.  If you are looking for a deep pocket, look no further than Walmart.  The question facing Puerto Rico was how to get more money out of Walmart without actually targeting the corporation (that would be unconstitutional.)

The territory, instead, tinkered with an old law to created a tax hikes which on the face seemed neutral.  However, the law, according to Walmart, targeted primarily the large retail corporation. The after-tax effect of the corporate alternative minimum tax change was to raise Walmart’s Puerto Rican tax liability to over 90% of its income.

How did we get here? Last year, Puerto Rico enacted Act 72-2015 (Act 72) into law. The key component of the act was an increase in the Tangible Property Component (TPC) of the corporate AMT.  According to prior reporting, “The TPC piece of the AMT imposes a tax on the value of property transferred to an entity doing business in Puerto Rico from a related party outside of Puerto Rico.”

Then last December, Walmart filed suit styled, Wal-Mart Puerto Rico Inc. v. Zaragoza-Gomez, 15-cv-3018, U.S. District Court, District of Puerto Rico (San Juan) challenging Act 72.  According to Walmart, the tax was unconstitutional violating the commerce clause.  Moreover, the new tax raised the company’s estimated income tax to “an astonishing and unsustainable 91.5% of its net income.”

In March of 2016, the District Court agreed with Walmart and in a 109 page opinion stated, “Puerto Rico’s AMT, on its face, clearly discriminates against interstate commerce.”  Part of the story told by bond holders, is that in the course of the trial, it came to light the government of Puerto Rico might have been misleading their bond holders and this law was a kind of hail-mary.  Per the UBS report, “In the course of the trial, senior officials of the García administration were obliged to provide sworn testimony. Judge Fusté’s subsequent written opinion provided information that had been either knowingly or inadvertently withheld from investors by the Government Development Bank.”  So, yes, the tax was targeted at Walmart.  Also, the government of Puerto Rico was also not disclosing to its bond holders the true economic conditions.

Late last week, the 1st Circuit agreed with the District Court.   The 1st Circuit concluded, “As to the merits of the Commerce Clause challenge, the AMT is a facially discriminatory statute that does not meet the heightened level of scrutiny required to survive under the dormant Commerce Clause.”

The 1st Circuit rejected Puerto Rico’s argument that “that even if the AMT is discriminatory on its face or in effect, it survives dormant Commerce Clause scrutiny because it is ‘a proxy for the tax that would be imposed upon profits that are shifted to related parties.'”  More specifically, the Court stated “[t]he amended AMT is a blunt and unnecessarily overinclusive approach to combatting profit-shifting abuse. It essentially establishes an irrebuttable presumption that all intercorporate transfers to a Puerto Rico branch from related mainland entities are fraudulently priced to evade taxes. In fact, the Secretary all but admits that there are narrower alternatives that target profit-shifting.”

The case may not be done yet and has a real chance of certiorari by the Supreme Court.  I say this for two (maybe two and half) main reasons:

  1. Walmart asked for an injunction prior to paying the tax and asking for a refund.  Both the District Court and the 1st Circuit thought the case was ripe because Walmart had started to make quarterly payments on the liability they would challenge.  Not so sure this is correct.  Also, there is a real Butler Act issue could also generate interest by the Court.
  2. The Dormant Commerce Clause issue is a “hot” one at the Supreme Court level.  The heart of the Wynne decision was DCC.  Maybe, Thomas wants another bite at the apple and this case could see the Supreme Court. (Although, this is not likely with Scalia’s passing).

One final thought.  The topic of the relationship between the US and its territories is not spoken or written about very often.  Puerto Rico, the US Virgin Islands, Guam and America Samoa are all territories.  There are similar foreign tax issues that arise when a US firm does business in the territory.  But in addition to treating those territories as separate, the Constitution still overlays the relationships.  In the recent past, there has been tax gaming schemes designed around the domestic/foreign treatment of the territories.

For example, if you file a federal tax return in the islands is that return also filed for purposes of the IRS?  That question is not so easily answered, see, e.g., Estate of Sanders, 144 T.C. No. 5 (2015)(where the tax court held that, a bona fide USVI resident, who filed a timely return with the BIR had the statute of limitations on assessments run and the IRS could not assess additional tax liability or penalties against him).

Also here we are talking about a common transfer pricing issue that internationally would be no problem if Puerto Rico were the Bahamas.  But since, Puerto Rico is separate but equal, the DCC also applies.  Here, even though “the Secretary admitted at the evidentiary hearing that there was no reason to believe that Wal-Mart PR had actually been engaging in abusive profit-shifting, the general problem of artificial profitshifting by multistate corporations is the object of a legitimate state interest.”  The 1st Circuit was unpersuaded, “The amended AMT is a blunt and unnecessarily overinclusive approach to combatting profit-shifting abuse. It essentially establishes an irrebuttable presumption that all intercorporate transfers to a Puerto Rico branch from related  mainland entities are fraudulently priced to evade taxes.”

This leads me to two final thoughts.  One,  a newer version could past muster. Two, is there something that MNCs could take from the 1st Circuit language to help in more generic transfer pricing arguments.  Essentially, could Walmart piggy back on this decision to try to reverse engineer a transfer pricing plan?

One thought on “Walmart and Puerto Rico

  1. One of the interesting things about Wynne and the Walmart PR case is the use of the internal consistency test to find discrimination against interstate commence. The internal and external consistency tests were formed to implement the “fair apportionment” prong of the Complete Auto test (no cite to CA the Walmart case? C’mon!). Apportionment wasn’t the issue here (though it could have been, I think, if the tangible property component attributed too much activity to PR), so should internal consistency have been mentioned at all? I agree that the tax is discriminatory by only including transactions between interstate related parties; I don’t think we need the internal consistency test to prove that. Does the recent use of the internal consistency to prove discrimination potentially limit how discrimination can be found, or is it just a subset of discrimination?

    To move into hypos, why didn’t PR just expand the tangible property component to cover all related transactions (will it now?). I’m sure there are tons of political issues with that, but it would satisfy internal consistency. Doing so could open the door to an external consistency challenge, but say that the transfers were all reasonably related to PR. What would be interesting is if the courts decided to address the fourth prong of Complete Auto–that the tax be fairly related to state provided services/benefits–how much is too much? A SALT person can dream…

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