Tax and fiscal enviroment in Puerto Rico today

© 2016 Kevane Grant Thornton. All rights reserved.
Conference -
Tax and fiscal environment
in Puerto Rico today
December 13, 2016
Caparra Country Club
San Juan, Puerto Rico

@2016 Kevane Grant Thornton LLP. All rights reserved.
Disclaimer
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taking a decision on any topic addressed in this presentation.

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Fiscal and financial oversight
in Puerto Rico
Ojel Rodríguez
Advisory partner
CPA/ABV, CVA, CIRA, CISA, CIA, CFE
Marta Rodríguez
Advisory manager
CPA/CVA, CGMA

© 2016 Kevane Grant Thornton LLP. All rights reserved.
Governance and
management
aspects of the
Puerto Rico
Oversight Board
Requirements of
fiscal plan
Economic growth
under PROMESA
Infrastructure
revitalization
Public debt
restructuring and
issuance
Agenda
1 2 43 5

Overview of PROMESA
• Signed into law by President Obama on June 30, 2016
• Creates a structure for exercising federal oversight of the fiscal
affairs of Puerto Rico
• Establishes an oversight board with plenary authority over Puerto
Rico's financial, budgetary, and legislative processes
• Provides relief from creditor lawsuits through the enactment of a
temporary stay on litigation
• Creates two alternative methods to adjust unsustainable debt
• Expedites approvals of key energy projects and other "critical
projects" in Puerto Rico

Overview of PROMESA
Title I
• Establishment & Organization of Oversight Board
Title II
• Responsibilities of Oversight Board
Title III
• Adjustment of Debts
Title IV
• Miscellaneous Provisions
Title V
• Puerto Rico Infrastructure Revitalization
Title VI
• Creditor Collective Actions
Title VII
• Sense of Congress Regarding Permanent, Pro-Growth Fiscal Reforms

Eligibility and requirements of Board members
• PROMESA requires the Board's members to meet the following criteria:
– has expertise in finance, municipal bond markets, management,
law, or the organization or operation of business or government
– is not a candidate for elected office
– is not an elected or appointed official
– is not an employee of the territorial government
– is not a former elected official of the territorial government
• Tenure of members:
– the term of a member of the Board shall be three (3) years
beginning the date of appointment
– the term of the Chair will be two (2) years or until a successor is
appointed
Reference: Section 101

Board's composition
Speaker of the
House of
Representatives
Speaker of the
House of
Representatives
Senate Majority
Leader
Minority Leader
of the House
Minority Leader
of the Senate
President’s
discretion
Nominee 1
Nominee 2
Nominee 3
President of the United
States
Governor or
his/her designee
Nominee 1
Nominee 2
Nominee 3
Nominee 1
Nominee 2
Nominee 3
Nominee 4
Nominee 1
Nominee 2
Nominee 3
Nominee 1
Nominee 2
Nominee 3
Member 1 Member 2 Member 3 Member 4 Member 5 Member 6 Member 7 Member 8
(non-voting)

Board's composition (continued)
Republican Nominees Democratic Nominees
Carlos García
former president
of the Puerto Rico
Government
Development
Bank
President of the United
States
Arthur González
former chief judge
of the US
Bankruptcy court
in Manhattan, NY
José Carrión III
insurance
executive based
in San Juan
Andrew Biggs
American
Enterprise
Institute fellow
Ana Matosantos
California's
finance director
from 2009 to 2013
José González
chief executive of
the Federal Home
Loan Bank of New
York
David Skeel
law professor at
the University of
Pennsylvania
Reference: https://juntasupervision.pr.gov/
Governor's designee
Elias Sánchez

Executive Director and Staff
• Appointed by the Chair with the consent of the Board members
• Will execute the instructions of the Board and be subject to the
supervision and control of the Board
• Will have general supervision and direction of the business affairs of the
Board
• Subject to the approval of the Board, may enter into and execute on
behalf of the Board contracts as he/she deems appropriate
• The Board is responsible for establishing the salary compensation (no
ceiling or limits are established)
• The Executive Director may hire and fix the pay of, and remove
additional personnel employed by the Board, as he/she deems
appropriate

Board's bylaws
• The Board's bylaws were approved on September 30, 2016 during the
Board's first meeting in New York
– the bylaws are based on PROMESA's sections
• All actions of the Board shall be taken by an affirmative vote of no fewer
than four (4) members and in accordance to section 206(v) of the Act,
an affirmative vote of no fewer than five (5) members is required to
issue a restructuring certification
• Board must meet at least quarterly
• To the greatest extent possible, the Board shall produce all of its written
materials in English and Spanish
• The Board shall submit and make public an annual report which will
include audited financial statements and adopted budget

Scope of the Board
• 63 public entities are covered under PROMESA's dispositions and
therefore under the supervision of the Fiscal and Oversight Board,
among them:
– PR Aqueduct and Sewer Authority (PRASA)
– PR Electric Power Authority (PREPA)
– Fiscal Agency and Financial Advisory Authority (AAFAF)
– PR Sales Tax Financing Corporation (COFINA)
– Puerto Rico Industrial Development Company (PRIDCO)
– University of Puerto Rico
– Governmental Development Bank for PR (GBD)
– Public Corporation for the Supervision and Deposit Insurance of
Puerto Rico Cooperatives (COSSEC)

Procedures on Transactions Involving
Covered Entities
• On a letter dated November 23, 2016, the Board shared additional
procedures regarding transactions involving covered entities
• The Board stipulated that:
– transactions of covered instrumentalities that are subject to
Approval under PROMESA, must be submitted to the Board no less
than 15 calendar days prior to its required approval
– the clock for such 15 days will start when the Board confirms it has
received all the information required for its review
– the Board can delay the transaction and take additional time for its
review in the case of complex transactions or in the case the Board
believes it requires additional information

Procedures on Transactions Involving
Covered Entities (continued)
• In addition, the approval request must include at least the following
information:
– a detailed memorandum explaining all the details of the transaction
including purpose, reasons why the transaction is the best public
interest, financial resources required and summary of all principal
legal documents required to execute
– letter evidencing approval by the Fiscal Agency and Financial
Authority of Puerto Rico and its rationale for approval
– letter from the Office of the Governor of Puerto Rico endorsing the
transaction and rationale
– legal opinion supporting why the transaction is covered under
PROMESA and under what legal basis the transaction can be
approved by the Board

Litigation stay
• PROMESA suspends certain legal actions against Puerto Rico
for debt payments and remedies allowing Puerto Rico to:
– address its immediate fiscal crisis
– negotiate with creditors instead of defending itself against
multiple lawsuits
– improve its governance
– pursue debt restructuring and liability adjustments
– resolve long-standing fiscal issues so it can return to
economic growth
• The stay would remain in effect until February 15, 2017 or six
months after the Board is established

Who will pay for the Board?
• Members shall serve without
compensation but may be
reimbursed for reasonable and
necessary expenses
• Puerto Rico Government shall
designate a dedicated funding
source within 30 days of the
enactment of the bill
• The Board may use its powers to
ensure that there are sufficient
funds to cover its operation
$370 million*
over a 5 year period
(FY2017-FY2022)
* CBO estimate
Reference: Section 107; Congressional Budget Office

How powerful is the
Oversight Board?
How powerful is the
Oversight Board?

Powers of the Board
Section 104 of PROMESA describes the Board's broad powers. The Board
has the power to:
• hold hearings and seek testimony, and receive evidence
• obtain information and records from federal agencies, Puerto Rico and its
creditors
• issue subpoenas for testimony or records
• enforce a law that prohibits public sector employees from participating in a
strike or lockout
• ensure the electronic payment and administration of taxes
• seek judicial enforcement of its authority
• investigate and publicize disclosure and sales practices related to bonds
purchased by retail investors
• accept gifts, bequests and devises of services or property, as long all gifts
and donors are disclosed within 30 days

What does the Board's fiscal plan entails?
• The Board requires the Governor to develop compliant five-year
fiscal plans (at least)
• If the government fails to develop a compliant fiscal plan, the
Board shall develop and certify a fiscal plan
Development
and
submission
Review by
Board
Notice of
violation
Revision by
Governor
Approval

Means to approve the fiscal plan
• Submitted by the Governor and approved by the Board
– the plan meets the 14 requirements outlined in PROMESA
• Developed and approved by the Board
– if the Governor fails to take corrective actions on the
recommendations of the Board
• Jointly developed by the Board and the Governor
– the bill allows the Board and the Governor to work
collaboratively to develop a consensus plan

PROMESA – Fiscal Plan Requirements
1. Provide for estimates of revenues and expenditures in conformance with
agreed accounting standards and be based on (i) applicable laws, or (ii)
specific bills that require enactment in order to reasonably achieve the
projections of the Fiscal Plan
2. Ensure the funding of essential public services
3. Provide adequate funding for public pension systems
4. Provide for the elimination of structural deficits
5. For fiscal years covered by a Fiscal Plan in which a stay under titles III or IV
is not effective, provide for a debt burden that is sustainable
6. Improve fiscal governance, accountability and internal controls
7. Enable the achievement of fiscal targets
8. Create independent forecasts of revenues for the period covered by the
Fiscal Plan

PROMESA – Fiscal Plan Requirements cont’d
9. Include a debt sustainability analysis (“DSA”)
10. Provide for capital expenditures and investment necessary to promote
economic growth
11. Adopt appropriate recommendations submitted by the Oversight Board (under
Section 205(a) of PROMESA)
12. Include such additional information as the Oversight Board deems necessary
13. Ensure that assets, funds, or resources of a territorial instrumentality are not
loaned to, transferred to, or otherwise used for the benefit of a covered
territory, unless permitted by the constitution of the territory, an approved plan
of adjustment under title III, or a Qualifying Modification approved under title
VI
14. Respect the relative lawful priorities or lawful liens, as may be applicable, in
the constitution, other laws, or agreements of a covered territory or covered
territorial instrumentality in effect prior to the date of enactment of PROMESA

Puerto Rico Government Fiscal Plan
• Governor Garcia Padilla formally presented Puerto Rico's Fiscal Plan on
October 14, 2016
• On November 9, 2016, the Board open an invitation to comment on the Fiscal
Plan (November 23 was the extended its due date for comments submission)
– A total of 114 comments were received, fifty percent coming from Puerto
Rico residents. Made public by the Board on December 8.
• On November 23, 2016, the Board issued an assessment of the fiscal plan in
which the following was addressed:
– convey the reasons why the Board rejected the fiscal plan submitted by
Governor García Padilla
– provide a timeline for the Board to certify a fiscal plan
• The Board understand that "more policy adjustment, particularly with respect to
structural reforms, is necessary for the Puerto Rico economy to return to
sustainable growth“

Rebuttal of fiscal plan – evaluation principles
• The Board established five (5) principles, in addition to the criteria set
forth in PROMESA Section 201(b), which the plan must meet in order to
be accepted:
• Cover at least
the next 10
fiscal years with
meaningful
progress in the
next five (5)
• Meet the
standards set
forth in the law
(14
requirements)
• Achieve the
Board's main
objective
• Assume no
additional
federal support
beyond that
which is already
established by
law (e.g. no
Affordable Care
Act support
extension and
no reliance on
Act 154
revenues)
• Include an
appropriate mix
of structural
reform, fiscal
adjustment, and
debt
restructuring
supported by
the relevant
analytical tools
(e.g. debt
sustainability
analysis and a
detailed
economic
projection)
Achieve the
following:
• stabilize current
economic
situation
• increase the
economy's
resilience
• shore up public
finances
• support long-
term growth
• meet basic
needs of
citizens
• Must include
relevant
operational
plans that show
the
Government
will achieve the
changes and
reforms it
proposes
Principle Principle Principle Principle Principle

Fiscal Plan certification timeline
Publication of
Baseline
Projections for
the Fiscal Plan
and principles
for achieving
balance
December 9th
Working
Session on
Fiscal and
Economic
Plan
Fiscal and
Economic Plan
Draft presented
Meeting to
discuss
revised
version of
Fiscal Plan
Distribution to the
public of revised
Fiscal Plan and
invitation to open
good-faith
negotiations with
creditors
Week of
December 19th
December 12th
December 15th
Revised
version of
Fiscal Plan
to be
submitted to
the Board
Week of
January 16th
January 31st
Target Date for
Certification of
Fiscal Plan

Annual and quarterly budgets
• Once a fiscal plan is approved, the governor shall submit annual
and quarterly budgets compliant with the fiscal plan
– the Board will be submitting revenue estimates for the period
covered by the budget
– approval process is similar as the one for the fiscal plans
• The Governor would also be required to submit quarterly "budget
vs actual" reports in the following areas:
revenues expenditures cash flows

Inconsistencies in the budget vs actual reports
• Inconsistencies would require explanation and corrective action
by the Governor
– if the Governor fails to take corrective action, the Board would be
required to notify the US House and Senate
– the Board has the powers to address directly the inconsistencies
identified

Financial stability and management
responsibility
• The Board may submit recommendations, at any time, to address fiscal
and management matters, e.g.
– privatization of public entities
– alternatives for paying employee pensions
– performance-based personnel systems
– modification or transfers of the type of services delivered by
governmental entities
– reduce government's non-debt expenditures
– implement hiring freezes / layoffs in the public sector
• The government would have to adopt the recommendations within 90 days
– if rejected, the governor must submit a statement to the President and
Congress explaining why the recommendations were rejected

Review of laws, contracts and executive orders
• Under PROMESA, the Governor would be required to prepare and
maintain a public registry of all contracts executed
• New contracts must be reviewed and approved by the Board
– the Board may enter into new contracts without Governor's approval
• Board may revoke any existing contract
• For any newly enacted law, the Governor shall submit a formal cost
estimate
– the Board has the power to certify and amend any proposed or new
law
– also has the power to revoke or amend any existing law, regulation
or executive order

Tax abatements and relief agreements
• PROMESA requires the Governor to submit a report
documenting all existing tax abatement or similar tax relief
agreements
• The Board reserves the power to execute or modify any tax
abatement or relief agreement without limits to what constitutes
the limit of power
• This report would not be disclosed to the public in order to
comply with regulation regarding confidential taxpayer
information

For how long would the Board operate?
• The Board would be operating until it determines and certifies that
Puerto Rico has achieved the following:
– obtained access to short-term and long-term credit markets at
reasonable rates of interest, and
– balanced budgets for four (4) consecutive fiscal years

Detroit vs Puerto Rico Fiscal Boards
Reference: Dentons

Economic growth under PROMESAEconomic growth under
PROMESA

Overview of Puerto Rico's economy
2.7%
1.9%
0.5%
-1.2%
-2.9%
-3.8% -3.6%
-1.7%
0.5%
-0.1%
-1.7%
-0.6%
-2.2%
-2.8%
-3.3%
-1.7%
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Annual Real GNP Growth
• The local economy has experienced secular deceleration in economic growth
since the mid 1970s
• GNP growth has been negative every year since 2007 with the exception of
2012 (0.5%)
• Significant decrease in investment weakened the economy
– investment in construction fell from nearly $7.0 billion (1999) to around $3.4
billion (2014)
Reference: Government Development Bank for Puerto Rico

• Government overspending lies at the root of the current the fiscal crisis
– from 2001 to 2013, accumulated budget deficits exceeded $20 billion.
During the same period $42 billion in debt was issued, half of which was
used to cover budget deficits
463.9
1,671.6
201.3
937.6 1,013.0
1,855.8
844.6 965.0
3,180.1
2,651.9 2,464.7
3,298.6
1,322.8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Fiscal deficits
Reference: Office of Management and Budget

• Outmigration reached historical levels with the loss of approximately 331,000
people or 9% of the total population in the period between 2006 and 2015. This
has led to an aging of the remaining population, a decreased net birth rate and
declines in Puerto Rico’s tax base.
– Recent data also suggest that the rate of outmigration continues to increase
Reference: Office of Management and Budget
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
3.4
3.45
3.5
3.55
3.6
3.65
3.7
3.75
3.8
3.85
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
(inmillions)
Total population and outmigration
Population Annual outmigration
Source: U.S. Census Bureau

• Puerto Rico and its various government instrumentalities
owe around $68.7 million in debt
– extraordinarily complex
• 18 different issuers, including the Commonwealth
itself, financing entities, and operating entities that
provide essential public services
– debt is held by countless and diverse creditors, including
retail holders (both on- and off- island), hedge funds,
mutual funds, local credit unions and mainland
institutional investors, each with different interests and
motivations in a potential restructuring
Reference: PROMESA Overview Presentation – Government of Puerto Rico

Congress's point of view
• Section 701 expresses Congress's point of view regarding
fiscal reforms for Puerto Rico:
“any durable solution for Puerto Rico’s fiscal and economic
crisis should include permanent, pro-growth fiscal reforms
that feature, among other elements, a free flow of capital
between possessions of the United States and the rest of
the United States.”

Congressional Economic Task Force
• Composed of eight (8) members, this task force is responsible of
issuing a report by December 31, 2016, that would examine:
– the relation of federal laws and economic growth in Puerto Rico;
– economic consequences of a Puerto Rico Department of Health
Regulation 346, which relates to natural products, natural
supplements, and dietary supplements; and would
– recommend changes to federal laws to spur sustainable, long-term
economic growth;
– recommend changes to federal law and programs that would reduce
child poverty; and
– include additional information as deemed necessary

Congressional Economic Task Force
(continued)
• On September 15, 2016, the Task Force
issued its first status update in which the
Task Force highlighted its concerns
regarding "the relative lack of reliable data
pertaining to certain aspects of the
economic, financial, and fiscal situation in
Puerto Rico"
• They received over 335 proposal
submissions from individuals and
organizations regarding economic growth
initiatives for Puerto Rico
• The Task Force would be terminated once
the report is issued by December 31, 2016
Congressional Task Force
members
Congressional Task Force members
are:
1. Senator Orrin Hatch (R-UT)
2. Senator Robert Menéndez (D-NJ)
3. Senator Marco Rubio (R-FL)
4. Senator Bill Nelson (D-FL)
5. Representative Tom MacArthur
(R-NJ)
6. Resident Commissioner Pedro
Pierluisi (PR)
7. Representative Sean Duffy (R-
WI)
8. Representative Nydia Velázquez
(D-NY)
Reference: https://pierluisi.house.gov/

Economic growth proposals (most discussed)
Reference: http://pierluisi.house.gov/; Private Sector Coalition; US Department of Health and Human Services
Health
• Parity in Medicare and Medicaid Federal funding
• Elimination of HIT Tax in Puerto Rico
• End the exclusion of territories from Part D of Low-Income Subsidy Program
Jones Act and Maritime Transportation Reform
• Reform or modification of the Jones Act
• Amend Section 808 of Law 108-176 of December 2003, also known as the Stevens
Amendment (United States presence in global air cargo industry)
Energy
• Extend the authority of the Federal Energy Regulatory Commission to review and
regulate local energy industry
• Extend the Investment Tax Credit for Renewable Energy in Puerto Rico until 2018
Social Security
• Implement a 50% reduction in the social security tax for workers, employers and the
self-employed for a period of six (6) years

Economic growth proposals (most discussed)
Reference: http://pierluisi.house.gov/; Private Sector Coalition; US Department of Health and Human Services
Other exemptions
• 85% exemption on dividends (or repatriation payments) from eligible Puerto Rico
companies, as defined
• Reduction in half of the full US statutory tax for active Puerto Rico source income on
the remaining 15%
Medicaid
• Lift the Federal cap on Medicaid funding to Puerto Rico and other US territories
• Raise the Federal Medicaid share from 55% to 83% over time
• Expand eligibility of Medicaid program to anyone who is earning less than 100% of the
Federal poverty level
Medicare
• Improve hospital payments related to low income patients and uncompensated care
• Increase payment rates for hospitals
Extend the Earned Income Tax Credit to Puerto Rico
Extend the Child Tax Credit to Puerto Rico

An opportunity for growth – HUBZone
• Designed to encourage economic development and job creation in
historically underutilized business zones through a certification and
designation process
• Companies and small businesses that become HUBZone-certified by
the SBA receive preferential treatment in Federal government
contracting over regular businesses
• HUBZone program requires that 3% of all Federal government's
contracting dollars be assigned specifically to HUBZone certified
businesses
Reference: Section 412; SBA.gov

An opportunity for growth – HUBZone
• Section 412 of PROMESA eliminates the 20% restriction from the
qualified census tract definition (for Puerto Rico only) until the first of the
following events occur:
– 10 years after the date that the SBA Administrator implements the
amendment; or
– the date on which the Board ceases to exist
• With this amendment, more areas could now qualify for the HUBZone
designation providing local small businesses the chance to benefit from
federal contracting opportunities

Other provisions
Reference: Title IV
• PROMESA allows Puerto
Rico (with the Board's
approval) to establish a
$4.25 minimum wage for
employees younger than
25
• The rate could last as
long as four years or until
the board terminates
• Current federal minimum
stands at $7.25 an hour
for non-exempt
employees ($15.00 in
some states)
• The bill won't restrict
Puerto Rico's right to
determine its future
political status by
plebiscite
• PROMESA excludes PR
from the USLD's overtime
pay rule which is
scheduled to take effect
on December 1, 2016
• The rule would raise the
salary threshold for white-
collar workers (exempt
workers) from $23,660 to
$47,476
• Employees who earn less
than the threshold amount
would be eligible for
overtime pay
• The exemption would be
in effect until GAO
determines that the rule
wouldn't negatively affect
the island's economy
Minimum wage
Exemption from
Overtime Pay Political status

Infrastructure revitalizationInfrastructure revitalization

How will infrastructure be revitalized?
• Title V of PROMESA establishes a process to accelerate the
development of infrastructure projects that provide essential services or
address threats to public health or safety
• Creates the position of "Revitalization Coordinator" and grants it the
following powers:
– a role in reviewing and permitting critical projects
– establish an expedited review process for such projects
– add related provisions intended to ease the permitting process and
increase the federal oversight role
• Critical project is defined by section 503 as:
– one that is intimately related to addressing an emergency whose
approval, consideration, permitting and implementation shall be
expedited and streamlined
Reference: Section 502 and 503

How will infrastructure be revitalized?
(continued)
• Physical infrastructure could involve projects related to:
• Projects could be proposed by a Puerto Rican agency or private entity
• The application would have to describe how the project addressed an
emergency, provide for estimated costs and the availability of funds to
support the project
energy water &
sewage
roads telecommunications other
systems

Public debt restructuring and
issuance

Summary of Debt Outstanding
Issuer Total Bonds and Private Loans (000's)
GO $12,896
COFINA 17,294
HTA 4,317
PBA 4,005
GBD 4,015
ERS 3,141
PRIFA 2,158
PFC 1,147
UPR 496
PRCCDA 386
PRIDCO 159
AMA 28
Other Central Gov't Entities 242
Plus/Less: Missed bond interest, GBD
and MFA Bonds 1,635
Total debt outstanding $68,707

How will the debt be restructured?
• PROMESA contains two methods (Title VI and Title III) to adjust Puerto Rico's
debts:
• As long as the Board remains in place, the territory including all of its
instrumentalities are prohibited of issuing new debt without the Board's approval
• Streamlined process to achieve
modifications with the consent of a
supermajority of creditors
• Benefits such as potential speed
relative to a traditional restructuring
through a formal in-court process
Voluntary adjustments
• Court-supervised debt-adjustment
process modeled after Chapter 9
• Includes "cram-down" power which
may provide Puerto Rico with
flexibility in debt adjustment
• Gives Board total control over the
adjustment process
• Includes certain provisions designed
to protect creditor interests
Court reviews
Reference: Title III, Title VI

Title VI and Title III Overview
Comparison Chart
Area Title VI Title III
Application
• Bonds, loans, or other borrowings
predating enactment of the Act
• Substantially all liabilities predating the
petition
Eligible
issuers
• The Commonwealth and also any
covered territorial instrumentality
explicitly authorized by the Board
• The Commonwealth or covered
territorial instrumentality for which
Board files a petition
Prerequisites
to relief
• There is no prerequisite to entry,
but a successful Title VI
modification requires that the
modification satisfy certain
conditions
• Board determines, among other things
that the debtor made good-faith efforts
at consensual restructuring, adopted
procedures to provide timely audited
financials, published draft financial
statements and other information
required to assess restructuring, and
adopted a fiscal plan
Proposals
• The debtor or the Oversight Board
makes the restructuring proposal
• Only the Board may file a petition or a
plan of adjustment

Title VI and Title III Overview
Comparison Chart (continued)
Area Title VI Title III
Process
• Issuer or holders propose a Modification and
the Board places affected bonds in pools based
on their priority and security features; with
limited exceptions, the proposed modification
must provide all holders in all pools the same
consideration pro rata
• The Board certifies that the modification is
consistent with the fiscal plan or, if no fiscal
plan exists, that it provides sustainable debt
• In order to become effective and bind non-
consenting holders, holders of at least two-
thirds in amount of the outstanding principal
amount of the bonds that vote consent,
provided further that such two-thirds must also
constitute a majority in outstanding principal
amount (for any secured bonds, non-
consenting holders either retain their liens or
receive property of a value at least equivalent
to the value of the lesser of their bond claims or
the collateral securing such bond claims)
• A federal court approves the binding
modification
• Board files petition and plan
• The process and substance otherwise generally
follows Chapter 9 of the U.S. Bankruptcy Code,
except that confirmation standards include a
modified “best interests of creditors” test and
require that the plan of adjustment must be
consistent with the fiscal plan (which must
“respect” priorities and liens existing under
relevant constitution, law or agreement, but such
determination will be made by the Board)

Questions
& feedback

Accounting issues resulting from the
actual fiscal environment in Puerto Rico:
Accounting Estimates
Angiee Chico, CPA, CIA, CGMA
Audit partner

Accounting Issues Related to Accounting Estimated -
Accounts Receivable and Bad Debts Expense
An accounting estimate impacted by the current
economic environment is the collectability of
receivables.
Global and local economic downturn and fiscal crisis
have put at risk accounts receivable and constrained
cash flows.

Inevitably, no matter how good the credit department
and policies are, a company will have a customer that
does pay its debts.
This is simply part of doing business.

General Facts
Receivables represent oral promises of the
purchaser to pay for goods and services sold
Short-term extension of credit
Classify as either current – expect collection within
one year or non-current and trade or non-trade
receivables
Normally collected within 30 to 60 days
Largest uninsured asset on a company’s balance
sheet.

What Do You Do if You Are Having a Hard Time
Collecting the Accounts Receivable?
Every company needs a formal system to account
for, age, follow up and collect receivables.
Companies should assess more directly and timely
the collectability of their receivables.
Some accounts that don’t get paid require more
persuasive techniques, such as a call from you, an
attorney or a collection agency.

 Invoicing – establish a billing process that ensures
accurate invoices are sent on a timely basis. Ask about
payment at that time.
 Aging Accounts Receivable - age your accounts
starting with the project completion date, sale or service
date. Choose a payment date or payment terms. If you
don’t receive payment in that time, send a reminder or
past-due reminder. Keep a record of the age of each
account that isn’t paid under its terms. Accounts older
than the required payment terms need your personal
attention.

 Calling Your Customer – effective
communication, proactive approach; this gesture
might be enough to get payment and avoid a
collection agency or attorneys’ fees.
 Using Collection Agency or Attorney – should
be considered. Many small-business owners
choose not to file suit on receivables under a
certain amount and write off the transaction as
uncollected. You'll save time and keep the
transaction out of the public records.

Collectability and estimates for allowance for
doubtful accounts
• Watch for trends in accounts receivable. Companies
should assess more directly and timely the collectability
of their receivables, as write-offs or additional reserves
may be necessary.
• Losses from uncollectible receivables shall be recorded
if, based on current information and events, it is
probable that the company will be unable to collect all
amounts according to the contractual or business terms
of the receivable.

doubtful accounts
• Companies should consider to tighten the credit
policy and review regularly.
• Evaluate each individual customer. Consider prior
periods' experience and ability to pay.
• Negotiate payment plans to align to corporate
collection policies.

doubtful accounts
After proper evaluation and discussion, determine
adjustments required or estimate for uncollectible
accounts receivable.
• Direct Write-Off vs. Allowance Method
The company needs to determine how it will
report the money it will not collect.
Companies use either the direct write-off method
or the allowance method to record defaulted
sales.

doubtful accounts
• Estimating Uncollectible Balances
Determine how to calculate the portion that is
likely to be uncollected.
Allowances or adjustments should
be recorded in the correct period.
Be realistic!

How Accounts Receivable Impact the Rest of
Accounting
This estimate and corresponding analysis is critical
because of its impact in the rest of accounting.
 Affects working capital or free capital
 Limit investments and growth opportunities
 Limit shareholders payouts
 Inability to invest in new equipment or introduce new
products or services

Accounting
 Accounts Payable and Additional Debts
o Cash flow directly impacts the company's ability to
pay short-term liabilities, including any current portion
of long-term debt.
o May require to obtain additional financing or lines of
credit
 Results are reflected in the financial statements and
related disclosures, as applicable

Accounting
 Budgeting Implications
o Accounts receivable can impact the future expected income used
to make budgeting decisions
o If receivables included in income expectations are not paid as
expected, budgets can quickly become underfunded
 Collection Approach
o A higher percentage of overdue receivables can distract limited
accounting personnel from their daily routines in small
businesses, decreasing departmental productivity
o Aging of receivables can also increase the loss a company takes
due to bad debts write-offs or selling them to third-party
collections agencies

Accounting
 Ratio Valuations
o Oversight and monitoring of metrics and financial
covenants by banks, investors and creditors are more
tough when making lending or investment decisions.
o Since receivables are assets, account balances impact any
financial ratio based on assets, including the debt-to-assets
and assets turnover ratios.
o Because of its impact on cash flows, receivables also
impact liquidity ratios such as the current, quick and cash
ratios.
o The receivables turnover ratio is directly affected by the
average maturity of accounts receivable as well.

What is the next step?
Managing the company’s accounts receivable should
be one of its priorities. Create a plan!
Work as a team. Business owners, senior managers
and key personnel should be highly involved on a
day-to-day basis.
In good times and bad times the company needs to
ensure the accounts receivable are as current as
possible.

Impairment of investments
Johanna Pérez, CPA, CFE, CAMS, CGMA
Audit partner

Agenda
• Impairment definition
• Impairment indicators
• Accounting for other-than-temporary impairment
of investments
• Example
• Disclosure requirements
• New accounting standards

What is an Impairment of Investments?
• If, on each reporting date, a security is impaired
because its fair value is less than its amortized
cost basis, management must decide if the
impairment is either temporary or other than
temporary.
• An other than temporary impairment does not
mean the investment has been permanently
impaired, but that the carrying value is not
expected to recover through the holding period of
the security.

Impairment Indicators
• Significant deterioration in the earnings performance, credit rating,
asset quality, or business prospects of the investee;
• Significant adverse change in the regulatory, economic, or
technological environment of the investee;
• Significant adverse change in the general market condition or either
the geographic area or the industry in which the investee operates;
• A bona fide offer to purchase, an offer by the investee to sell, or a
completed auction process for the same or similar security for an
amount less than the cost of the investment;
• Factors that raise significant concerns about the investee’s ability to
continue as a going concern;
• Among others.

Impairment Indicators Applicable to Puerto Rico
investments
• Overall shrinkage of Puerto Rico's economy
• Default of bond payments by Puerto Rico
Government
• Degraded rating of Puerto Rico bonds by principal
credit rating agencies: Fitch, Standard & Poor and
Moody's
• Among others.

Impairment Indicators Applicable to Puerto Rico
investments
Rating Agency Date Rating Outlook
Standard &
Poor's
October 1983 A N/A
April 2016 CC Negative
Moody's September 1970 A N/A
April 2016 Caa3 Negative
Fitch January 2011 BBB+ Stable
April 2016 CC Rating Watch
Negative
sources: http://www.gdbpr.com/investors_resources/
UBS Municipal Brief April 7, 2016

Accounting for Other-Than-Temporary Impairment of
Investments
Guidance on other than temporary impairments is
prescribed by ASC 320-10-35 “Investments –
Debt and Equity Securities – Overall –
Subsequent Measurement”

Investments
• For equity securities, an other-than-temporary
impairment loss should be recognized in earnings
for the difference between the amortized cost and
fair value of the security at the balance sheet date.
The fair value becomes the new amortized cost
and should not be adjusted for subsequent
recoveries in fair value. (FASB ASC 320-10-35-34)

Investments
• For debt securities, the recognition of an other-than
temporary impairment loss depends on whether
the entity intends to sell the security (or whether it
is more likely than not it will be required to sell the
security) before recovery of the amortized cost
basis less any current-period credit loss.

Investments
• If the entity intends to sell the security (or more
likely than not will be required to sell the security),
the other-than-temporary impairment should be
recognized in earnings for the entire difference
between the amortized cost and fair value at the
balance sheet date.

Investments
• If there is no intention to sell the security or it is not
more likely than not the entity will be required to
sell, the other-than-temporary impairment should
be separated into amounts pertaining to (a) the
credit loss and (b) all other factors. The amount
relating to the credit loss should be recognized in
earnings and the remaining amount should be
recognized in other comprehensive income (net of
taxes).

Investments
• Compare the present value of the expected cash flows
versus the amortized cost
– PV of expected cash flow < amortized cost =
credit loss

Investments
• When developing an estimate of cash flows expected to be
collected, management should consider:
– Past events, current conditions, and reasonable and
supportable forecasts
• Remaining payment terms of the security
• Prepayment speeds
• Financial condition of the issuer
• Expected defaults
• Value of any underlying collateral

Investments
• The prior amortized cost less the impairment loss
recognized in earnings becomes the new
amortized cost. This amount should not be
adjusted for subsequent recoveries in fair value,
but should be adjusted for accretion and
amortization. (FASB ASC 320-10-35-34A through
34E)

Example
A company has an investment portfolio on which management identified
investments in debt securities (government securities – Puerto Rico) with a fair
value significantly lesser than its amortized cost.
Issuer
Amortized Cost
as of
12/31/2015
Coupon
Rate
Maturity
Date
Credit Rating
(Moody's/S&P)
Market Value as
of 12/31/2015
Market Value as
of 12/31/2015
Diff. between
BV and MV
%
Government
Development Bank
for Puerto Rico (I)
5,000,000$ 4.150% 8/1/2017 CA/CC 28.244 1,412,200$ 3,587,800$ 72%
Government
Development Bank
for Puerto Rico (II)
5,000,000$ 4.500% 8/1/2019 CA/CC 27.791 1,389,550$ 3,610,450$ 72%
10,000,000$ 2,801,750$ 7,198,250$

Example
0
50
100
150
2011 2012 2013 2014 2015
Market Value
Bond #1 Bond #2
Source: Bloomberg

Example
Circumstances for an OTTI have occurred and impairment
analysis:
 The entity intends to sell the security
 It is more likely than not that the entity will be required to
sell the security before recovery of its amortized cost basis
 The entity does not expects to recover the entire amortized
cost basis of the security

Example
Management assumptions:
Assumption Bond #1 Bond #2
Principal hair cut -20% -25%
Coupon interest adjustment -10% -10%
Maturity term extension
(years)
5 5

Example
Revised scenario based on management assumptions:
New terms Bond #1 Bond #2
Adjusted principal obligation $4,000,000 $3,750,000
Adjusted coupon interest 3.735% 4.050%
Monthly interest payments $12,450 $12,656
Term to maturity date (months) 79 103
New maturity date 8/1/2022 8/1/2024

Example
Impairment calculation: Credit related impairment loss estimate for the
Government Development Bank securities is based on the probability of
default and loss severity in the event of default in consideration of the debt
securities credit ratings and the latest available information about the Puerto
Rico’s Government’s financial condition, including the Puerto Rico
Government’s intention to restructure its outstanding bond obligations.
Bond #1 Bond #2 Total
Amortized cost $5,000,000 $5,000,000 $10,000,000
Present value of
expected cash
flows
$3,904,517 $3,630,034 $7,534,551
Impairment amount
(credit loss portion)
($1,095,483) ($1,369,966) ($2,465,449)

Journal Entry
Account Description Debit Credit
Impairment losses - current earnings 2,465,449$ -$
Unrealized losses - other comprehensive income 4,732,801 -
Impairment loss on investments - 7,198,250
7,198,250$ 7,198,250$

Presentation of Other-Than-Temporary
Impairment (Balance Sheet)
Balance Sheet
Investment in marketable securities 2,801,750$

Presentation of Other-Than-Temporary
Impairment (Income Statement)
Income Statement
Total other-than-temporary impairment losses (7,198,250)$
Portion of loss recognized in other comprehensive
income before taxes 4,732,801
Net impairment losses recognized in earnings (2,465,449)$

Disclosure Requirements
• ASC 320-10-50
– Methodology and significant inputs used to measure the
amount related to credit loss (recognized in earnings)
• Performance indicators such as default rates, delinquency rates,
percentage of nonperforming assets
• Loan-to-collateral-value ratios
• Third party guarantees
• Geographic concentration
• Credit ratings

Disclosure Requirements
• ASC 320-10-50
– Roll forward of the amount related to credit losses
recognized in earnings
• Beg. balance of credit losses for which a portion of an other-than-temporary
impairment was recognized in other comprehensive income
• Additions to the credit loss for which an other-than-temporary impairment was
not previously recognized
• Reductions for securities sold during the period (realized)
• Reductions for securities for which the amount previously recognized in other
comprehensive income was recognized in earnings because the entity intends to
sell the security or more likely than not will be required to sell the security before
recovery of its amortized cost basis

Disclosure Requirements (cont.)
• ASC 320-10-50
– Roll forward of the amount related to credit losses
recognized in earnings (cont.)
• If the entity does not intend to sell the security and it is not more likely than not
that the entity will be required to sell the security before recovery of its amortized
cost basis, additional increases to the amount related to the credit loss for which
an other-than-temporary impairment was previously recognized
• Reductions for increases in cash flows expected to be collected that are
recognized over the remaining life of the security
• The ending balance of the amount related to credit losses on debt securities held
by the entity at the end of the period for which a portion of an other-than-
temporary impairment was recognized in other comprehensive income.

Accounting Standards Update
• ASU No. 2016-01 – “Financial Instruments – Overall: Recognition and
Measurement of Financial Assets and Financial Liabilities” – which
amends the guidance in U.S. GAAP on the classification and
measurement of financial instruments.
Changes to the current GAAP model primarily affects the accounting for
equity investments, financial liabilities under the fair value option, and
the presentation and disclosure requirements for financial instruments. In
addition, the guidance related to the valuation allowance assessment
when recognizing deferred tax assets resulting from unrealized losses
on available-for-sale debt securities was clarified.
The ASU is effective for public companies for years beginning after
December 15, 2017 and for all other entities an additional year after that.

Accounting Standards Update
• ASU No. 2016-13 – “Financial Instruments – Credit Losses:
Measurement of Credit Losses on Financial Instruments” – which
amend the guidance on the impairment of financial instruments.
The new guidance introduces an approach based on expected losses
to estimate credit losses on certain types of financial instruments. It also
modifies the impairment model for available-for-sale debt securities and
provides for a simplified accounting model for purchased financial
assets with credit deterioration since their origination.
ASU is effective for public companies for years beginning after
December 15, 2019 and for non-public entities for years beginning after
December 2021.

Troubled debt restructuring
Kayra Rivera, CPA, CGMA
Audit director

• ASC 470-60 “Debt, Troubled Debt Restructurings by
Debtors” establishes standards of financial accounting and
reporting by the debtor for a troubled debt restructuring.
• ASC 405-20 “Liabilities, Extinguishments of Liabilities”
establishes standards of financial accounting and reporting
for extinguishments of all liabilities.

Accounting for debt modifications
• Basic types of transactions:
 Trouble debt restructurings
 Modification of terms of an existing debt
 Extinguishment of debt

Definition of troubled debt restructuring
• A restructuring of a debt constitutes a troubled debt
restructuring if:
(1) the borrower is experiencing financial difficulty, and
(2) the lender grants a concession that it would not have
otherwise considered

Factors to determine a troubled debt restructuring
• If a borrower's creditworthiness has deteriorated since its
debt was originally issued, it should then assess all aspects
of its current financial position to determine whether it is
experiencing financial difficulty.

TDR Identification – Two-Step Process
Step 1:
• Determine whether the borrower is experiencing financial
difficulties. Indicators include the following:
 the debtor is currently in default on any of its debt
 the debtor has declared or is in the process of declaring bankruptcy
 doubt about ability to continue as a going concern
 currently, the debtor has securities that have been delisted, are in
the process of being delisted, or are under threat of being delisted
from an exchange.

TDR Identification – Two-Step Process
Step 1:
• continuation -
 the debtor forecasts that its entity-specific cash flows will be
insufficient to service debt (both interest and principal) in
accordance with the contractual terms of the existing agreement
through maturity.
 absent the current modification, the debtor cannot obtain funds from
sources other than the existing creditors at an effective interest rate
equal to the market interest rate for a similar debt for a nontroubled
debtor.

TDR Identification – Two-Step Process (cont.)
Step 2:
• Determine whether modification is a concession.
 the effective borrowing rate on the restructured debt is less
than the effective borrowing rate of the original debt.
o the effective borrowing rate of the restructured debt is
calculated by projecting all the cash flows under the new
terms and solving for the discount rate that equates the
present value of the cash flows under the new terms to the
debtor's current carrying amount of the old debt.

TDR Identification – Two-Step Process (cont.)
Step 2:
• Examples include the following:
 Forgiving principal or interest
 Modifying interest rate to a below-market rate
 Deferring principal payments(e.g. interest only)
 Extending the maturity date

Troubled debt restructuring –
Settlement of debt
Involves most commonly the following:
Full settlement with assets or equity – if the debtor transfers
receivables from third parties or other assets or equity to the creditor
to fully settle a debt, it should recognize a gain on the transaction in
the amount by which the carrying amount of the payable exceeds
the fair value of the assets transferred.
Partial settlement with assets or equity – if the debtor
transfers receivables from third parties or other assets or equity to
partially settle a debt, it should only measure the transaction with
the fair value of the assets transferred (not the fair value of the
payable).

Accounting for a Settlement of debt –
Example – Exchange of assets
ABC, Inc. owes $300,000 plus $20,000 of accrued interest to
PR Bank. The debt is a 10-year, 10% note. During 2015, ABC,
Inc.’s business deteriorated due to a faltering regional
economy. On December 31, 2015, PR Bank agrees to accept
an old machine and cancel the entire debt. The machine has
a cost of $490,000, accumulated depreciation of $321,000,
and a fair market value of $290,000.

Accounting for a Settlement of debt –
Example (cont.)
Journal entries to be recorded:
ABC, Inc:
Notes Payable 300,000
Interest Payable 20,000
Accumulated Depreciation 321,000
Machine 490,000
Gain on Disposition of Machine 121,000 (a)
Gain on Debt Restructuring 30,000 (b)

Accounting for a TDR involving modification of terms
• When a borrower has a troubled debt restructuring (TDR) in
which the terms of its debt are modified, it should analyse
the future undiscounted cash flows to determine
appropriate accounting treatment.
• If the future undiscounted cash flows under the new terms
is lesser than the adjusted net carrying value of the original
debt -- a gain is recorded on the transaction.
• If otherwise, no gain would be recorded.

• In calculating the future undiscounted cash flows specified
by the new terms:
All payments under the new terms should be included
Any contingent payments should be included without
regard to the probability of those payments being made
If the number of future payment periods may vary
because the debt is payable on demand, the estimate of
future cash payments should be based on the maximum
number of periods that could be required under the
terms of the revised debt agreement

(cont.)

Example of Modification of terms –
Gain recorded
• On December 31, 2012, ABC Bank enters into a debt restructuring
agreement with DEF Company, which is now experiencing financial
trouble. The bank agrees to restructure a 12%, issued at par,
$2,000,000 note receivable by the following modifications.
 Reduce principal obligation from $2,000,000 to $1,300,000.
 Extend the maturity date from December 31, 2012, to December 31,
2015.
 Reduce the interest rate from 12% to 10%.
• DEF Company pays interest at the end of each year. On January 1,
2016, DEF Company will pay $1,300,000 in cash to ABC Bank.

Gain recorded (cont.)
Journal December 31, 2012:
Note Payable 310,000
Gain on Debt Restructuring 310,000
Total future cash flows after restructuring:
Principal 1,300,000$
Interest ($1,300,000 x 10% x 3) 390,000
1,690,000
Total pre-restructuring carrying amount
of note (principal): 2,000,000
Gain ($2,000,000 - $1,690,000) 310,000$

No gain recorded
• On December 31, 2012, ABC Bank enters into a debt restructuring
agreement with DEF Company, which is now experiencing financial
trouble. The bank agrees to restructure a 12%, issued at par,
$2,000,000 note receivable by the following modifications.
 Reduce principal obligation from $2,000,000 to $1,600,000.
 Extend the maturity date from December 31, 2012, to December 31,
2015.
 Reduce the interest rate from 12% to 10%.
• DEF Company pays interest at the end of each year. On January 1,
2016, DEF Company pays $1,600,000 in cash to ABC Bank.

No gain recorded (cont.)
• Under this example, no gain is recorded by DEF Company
since total future cash flows after restructuring exceed total
pre-restructuring carrying amount of the note (principal):
Total future cash flows after restructuring:
Principal 1,600,000$
Interest ($1,600,000 x 10% x 3) 480,000
2,080,000$
Total pre-restructuring carrying amount
of note (principal): 2,000,000$

Extinguishment of liabilities- ASC 405-20
General
• ASC 405-20-40-1 provides guidance on when a reporting
entity should extinguish a debt.
• A liability has been extinguished if the debtor either:
the debtor pays the creditor and is relieved of its
obligation for the liability
the debtor is legally released from primary obligation
under the liability, either judicially or by the creditor

Extinguishment of liabilities- ASC 405-20
What is considered?
• an exchange of debt with substantially different terms
• a substantial modification of terms
If the difference between the present value of the
cash flows of the new debt and the present value
of the remaining cash flows of the original debt is……

Extinguishment of liabilities-
Measurement of debt extinguishments
• For all debt extinguishments, the difference between the
reacquisition price and the net carrying amount of the debt
extinguished (which includes any deferred debt issuance
costs) should be recognized as a gain or loss when the
debt is extinguished.
– Extraordinary item – new guidance effective
• Transaction with related parties - recognition of gain or loss
may not be appropriate (such a restructuring may be in
essence a capital transaction).

Accounting for a Debt extinguishment

Chapter 11 bankruptcy proceedings
• since debtor would be restating its liabilities generally, this
subtopic would not apply to the debtor's accounting for such
reduction of liabilities.
• this subtopic would apply to an isolated TDR by a debtor
involved in bankruptcy proceedings if such restructuring did
not result in a general restatement of the debtor's liabilities.

Administrative Determination 16-14
Taxation of income due to debt forgiveness
• Section 1031.01 (a) (6) of the 2011 Puerto Rico Internal
Revenue Code, as amended (the "Code"), provides that, as
a general rule, the income or benefit derived from the
forgiveness of a debt is considered as part of the gross
income subject to income tax.

Certain amounts are excluded:
• The cancellation is the result of filing an application for
bankruptcy in an action under the provisions of Title 11 of
the United States Code.
• Student loans, in whole or in part
• Reorganization of a mortgage loan guaranteed by the
qualifying residence of the taxpayer, provided that the
original mortgage loan amount does not exceed
$1,000,000.
• Insolvency of the taxpayer

This Administrative Determination establishes the rules to
determine the amount exempt from debt forgiveness under
the following exclusions and also establishes the way to report
the income for debt forgiveness under such circumstances:
– reorganization of a mortgage loan guaranteed by the
qualifying residence of the taxpayer;
– when the taxpayer is insolvent
• Agreed upon procedures required

Francisco Luis, JD, CPA
Tax partner
Recent tax legislation affecting
multinational organizations

Topics
01 Act 40-2013
02 Circular Letters
03 Act 72-2015
04 Wal-Mart Case
05 Where are we now?

Background – Act 40-2013
• Act 40-2013 was enacted to impose, among others,
important limitations to Puerto Rico taxpayers that had
transactions with related parties not engaged in a trade
or business and not subject to tax in Puerto Rico, as
follows:
• established certain disallowance of expenses
incurred or paid to a related person ; and
• added new components to the Alternative Minimum
Tax ("AMT") computation.

Non-Deductible Expenses
• for ordinary tax purposes, Act 40-2013 established a
disallowance of 51% of the expenses incurred with a
related party that is not engaged in a trade or business
or subject to taxes in Puerto Rico (section 1033.17)

Alternative Minimum Tax
• the AMT of a corporation is the excess of, if any,
the tentative minimum tax over the regular tax.
• important changes:
2011 PR Internal
Revenue Code
Act 40-2013
AMT Tax Rate 20% 30%
Book Income
Adjustment
50% 60%
NOL Limitation 90% 80%

Alternative Minimum Tax
the tentative minimum tax is composed of the greater of:
• 30% of the alternative minimum net income,
or
• the sum of the following two items:
1. 20% of the expenses incurred or paid to related
parties and/or the expenses allocated from a home
office to a branch located in Puerto Rico, if such
payments were not subject to tax in Puerto Rico
during the tax year
2. up to 2% on the purchases of tangible personal
property from a related person

Authority to the Secretary of Treasury
• Act 40-2013 provided authority to the Secretary of
Treasury to approve waivers to exclude expenses
subject to the disallowance of 51% and the 20% charge
in the AMT. It was also authorized to waive also the
AMT on the transfer of personal property
– the Secretary was requested to issue guidelines on the
procedures to request such waivers

Waiver for expenses
• Circular Letter 13-06 was issued providing the
procedures to request the exclusion of certain expenses
incurred or paid to a related person with regards to:
– deduction of said expenses with regards to the 49%
limitation imposed for income tax purposes
– 20% tax under the AMT calculation
• under these sections, the Secretary may grant an
exclusion upon assessment of the nature of the
expenses or costs paid to related person or office

Waiver for expenses
• Circular Letter 13-06 required that among others a
Memorandum in support of the waiver should be filed
together with certain “Agreed Upon Procedures”
covering the 4 taxable years prior to the year for which
the waiver was being requested.
– the waiver, if granted would have been valid for 2
taxable years

Waiver for transfers of personal property
• Circular Letter 13-07 was issued to provide the procedure
for requesting a partial or total waiver from inclusion in the
AMT calculation of the purchase value of property acquired
from a related person or transferred from home office
• Secretary may grant a partial or total waiver to reduce the
tax rate limited to .2% when it is determined that the value
of the purchased property or transferred property to the
taxpayer was the same or substantially similar to the
value under which said related person sells the property
to an unrelated party.
• Pursuant to Act 40-2013, a transfer price study is required.

Circular Letter No. 13-23
• it was issued to clarify the term "eligible charges" to be
excluded from the 51% disallowance for ordinary tax
purposes and the AMT 20% charge.
– “eligible charges” are those that are expenses or directs
costs that are essential and meet the following criteria:
1) should be directly related to the operation of the
industry or trade or business in Puerto Rico
2) should be indispensable to make the operation viable
in Puerto Rico
It also indicated that the “eligible charges” should be those that
although paid to a related party, they are truly reimbursements
of expenses paid to non related third parties

Act 72-2015 changes
• Act 72-2015 brought the following significant changes
to the rules for related party transactions:
– it limited the amount of the expenses that the
Secretary could waive to 60% from the 51%
disallowance for ordinary tax purposes and from the
20% tax for AMT; and
– it also eliminated the waiver process for the purchases
of personal property and provided an increase on the
tax over those purchases from 2% to 6.5%, depending
on the taxpayer's gross revenues

Act 159-2015
Technical amendment to Act 72-2015
Waiver on Expenses with Related Parties
• it provides that the waiver request to exclude 60% of
the expenses incurred with a related party that is not
engaged in trade or business in Puerto Rico from the
51% disallowance for ordinary tax purposes and from
the 20% tax for AMT, should be made within the first
taxable year for which such waiver is being requested.
If granted, the waiver will be valid for a maximum of 3
taxable years.

Wal-Mart Action – First Instance
• on December 4, 2015, Wal-Mart initiated legal action
against the Secretary to challenge the changes
brought by Act 72-2015.
• the main focus of Wal-Mart's claim was particularly
with the AMT imposition on the purchases of personal
property as it is the area in which it received the most
impact.

• Wal-Mart requested an injunction against the
continued enforcement of the AMT provisions
sustaining that they were unlawful under the following:
– Dormant Commerce Clause
– Equal Protection Clause
– Bill of Attainder Clause
– Federal Relation Acts

• on March 28, 2016, the district court issued an order
stating its findings of fact and conclusions of law. It
held that:
1) it had jurisdiction under the Butler Act because of the
lack of a "plain, speedy and efficient remedy" in
Puerto Rico courts;
2) the AMT violates the Dormant Commerce and the
Equal Protection Clause;
3) the AMT violates the Federal Relations Act;
4) the AMT does not violate the Bill of Attainder Clause

Wal-Mart Action – The Court of Appeals
determination
• the Court of Appeals affirmed the District Court's
decision, therefore the injunction against the
enforcement of the AMT against Wal-Mart continues.
• it indicates that the District Court had jurisdiction over
Wal-Mart claims.

determination – Remarkable points
• the decision states that the AMT dispositions of Act 72-
2015 are discriminatory as it taxes only cross border
transactions between a Puerto Rico corporate taxpayer
and a related entity outside of Puerto Rico.
• furthermore, the Appeal's Panel concluded also that if
Act 72-2015 would have been valid, it would prevent
multistate corporations from enjoying the functional
integration, centralization of management, and
economies of scale associated with their interstate
business model.

• the decision mentions that Act 72-2015 is based on the
incorrect presumption that all intercorporate transfers
to a Puerto Rico branch from a related party are
fraudulently priced to evade taxes.
• it says that there are alternatives to validate if there is
an undue profit shifting as it is the case with "the
already existing set of regulations that authorize
the PR Treasury to conduct a traditional transfer
pricing audit of interstate transactions between
related parties and to adjust specific transfer
prices … to recapture improperly shifted profits."

• certainly, the Appeals Court decision reaffirms, not
only the unconstitutionality of these arbitrary
impositions on related party transactions, but
emphasizes the fact that Puerto Rico has regulations
to review transactions among related parties, similar to
those in the Federal Tax System.

• the Secretary of Treasury issued the AD 16-11 to
clarify the applicability of the AMT after the resolution
of the case with Wal-Mart
– for taxable years beginning after January 1, 2016,
the AMT computation will not include the charge on
the transfer of personal property and the 20%
charge on expenses with related parties not
engaged in a trade or business in Puerto Rico

• provides rules stating that if the amount of tax for
taxable year 2016, without considering the AMT
charges on transfer of personal property and
expenses, is already covered with the estimated tax
payments made, no additional estimated tax payments
are necessary.

• what about taxable year 2015?
– the AD 16-11 indicates that the taxpayer may
amend its 2015 tax return to eliminate the tax
portion that was attributable to the AMT
computations on personal property and expense, if
any.
• the excess tax paid should be claimed then as a
credit of income taxes or as an AMT credit for
future years.
• it specifically states that any excess tax paid can
not be requested as a refund.

• what about the 51% disallowance?
– the Secretary indicates that even though the AMT
charges on transfers of personal property and
expenses with related parties not engaged in trade
or business in Puerto Rico were declared
unconstitutional, the 51% disallowance continues to
be valid.

Transfer Pricing
Isabel Hernández, CPA
Tax partner

Agenda
• Overview
• Arm's Length
• History
• US Regulation
• OECD Guidelines
• PR Regulation
• Transfer Pricing Study
• BEPS

What is Transfer Pricing?
• The pricing of transactions between related parties,
such as a parent and a subsidiary.
• Companies undertaking transactions with
unrelated companies in the marketplace must set
competitive prices for goods they sell, services
they provide, or the use of intangibles, but
companies transferring goods or services between
entities do not have to set competitive prices.

• Deals with the evaluation of prices charged in transactions
between RELATED PARTIES
• Parties: Owned or controlled directly or indirectly by the same
interests
• Transactions:
– Sale, lease, use of tangible property
– Sale, license, use of intangible property
– Services
– Loans
Scope of Transfer Pricing

• Multinational companies operate in different countries with different tax
laws/tax rates
• Large companies can have difficulty determining where income is
earned
• Companies have incentives to transfer income to lowest tax
jurisdictions
• Companies can use transfer pricing as a planning opportunity to reduce
taxes
• In many countries, enforcing transfer pricing regulations is perceived to
be a significant revenue raising strategy used by the local tax
authorities
• In many countries, the local tax authority imposes significant penalties
for noncompliance with the transfer pricing regulations
Importance of Transfer Pricing

• Any multinational company that has intercompany transfers of
tangible property, services or intangibles
• Multi-state companies with intercompany pricing issues
• Companies with management objectives of determining
intercompany prices
• Companies whose transfer pricing policies are being audited
• Companies who have related party transactions involving
entities not part of a consolidated tax return
• Companies which require an analysis of the value of certain
functions and risks (ex: value of intangible property)
Types of Companies that Benefit from a
Transfer Pricing Analysis

• There are two options for meeting regulatory requirements: annual
report and Advance Pricing Agreements (APA)
Meeting Regulatory Requirements
• This is typically considered to be the
standard way to meet regulatory
compliance
• Companies must annually document
their activities (documentation
requirements vary by country) and be
ready to support a tax return filed
• This approach to regulatory
compliance is most common among
the clients as it is still the dominantly
chosen means for compliance
• An APA is an agreement between the taxpayer
and the Tax Authorities concerning the
methods the taxpayer will use to set its
transfer prices over some specified period of
time
• The main advantage of an APA is that it
reduces uncertainties both for taxpayers and
tax authorities, reducing the threat of penalties
• The main obstacle to an APA is the cost of
time and resources involved in negotiating
one successfully
• Under an APA, a company must still carry-out
the agreed methodology in order to determine
the appropriate allocation of profits
APAANNUAL REPORTING

• The arm’s-length standard is the fundamental basis of worldwide
transfer pricing regulations.
• A transaction is at arm’s-length if the transaction is consistent with
results of uncontrolled taxpayers engaged in comparable
transactions.
• Specific methods for analyzing intercompany transfers of tangible
goods, services and intangible goods are outlined in regulations under
Section 482 of the US IRC and Section 1040.09 of the PRIRC.
• When two or more transfers occur within the same company, the use
of more than one transfer pricing method may be needed.
• The arm’s-length standard is accepted by most developed and many
developing nations for intercompany transfers of goods, services, and
intangibles.
The Arm’s-Length Standard

General Overview of the Arm's Length
Standard…

• Arm’s-length Range: In most cases it is not possible to
identify a single price that would occur between unrelated
parties. Several comparable transactions can define an
arm’s-length range of possible results within which the
related party transaction to be priced should fall.
• Interquartile Range: When there are significant functional
and operational differences between the comparable
firms and the taxpayer, the interquartile range is used to
eliminate any outlying results.
• A transfer pricing method may produce a single reliable
result, or a range of reliable results.
The Arm’s-Length Range

Let’s talk about history

• Starting in 1920, countries began debating about
the consequences of double taxation
• In 1943 the first models of bilateral agreements
were created
• In 1960 the US, Canada and 18 European
countries joined to create the Organization for
Economic Cooperation and Development (OECD)
Where does transfer pricing come from?

• In 1979 the OECD published “Transfer Pricing and Multinational
Enterprises”
• In 1995 the OECD published "Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations", which is what
we have today as amended in 2010
• OECD Member countries are: Australia, Austria, Belgium,
Canada, Czech Republic, Denmark, Finland, France, Germany,
Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea,
Luxembourg, Mexico, Netherlands, New Zealand, Norway,
Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland,
Turkey, United Kingdom, United States.
OECD Member Countries

• U.N. members like China, India, and Brazil have adopted
positions that would seem difficult to reconcile with the
OECD TP Guidelines and the US TP Regulations.
• The U.N. manual published on October 15, 2012
confirms that developing countries have acquired
independent views on transfer pricing, presumably to
ensure that a larger share of the profits of multinational
enterprises are subject to taxation in developing
countries. This was a sign that “the U.N has abandoned
the neutral position toward the OECD TP Guidelines.”
Non-OECD Member Countries

• The goal of transfer pricing, for tax purposes, is to prevent income
shifting through inter-multinational companies’ transactions. The arm’s
length principle is the standard used for that purpose.
• Historically speaking, the arm’s length principle was first stated in US
Regulations under §482 (“US TP Regulations”) of the IRC code in 1934.
In this regard, the U.S. was the first promoter of the adoption of the
arm’s length standard in the first OECD Model Income Tax Convention
released in 1963.
• Thus, the OECD guidelines on transfer pricing (“OECD TP Guidelines”)
matter was influenced deeply by the US. The arm’s length principle has
since gained acceptance in all OECD members as a fundamental
principle governing international transfer pricing.
Background

Transfer Pricing Legislation

• I.R.C. Section 482, Treasury Regulations 1.482
• Transfer Pricing Guidelines of the Organization for Economic
Cooperation and Development (“OECD Guidelines”) (revised 2010)
• U.N. Practical Manual on Transfer Pricing (2009)
• PR Section 1040.09 and Proposed Regulation 8049
Transfer Pricing Legislation (cont.)

U.S. Regulation

• Section 482 authorizes the IRS to reallocate
income among related parties in order to prevent
evasion of taxes or clearly to reflect the income of
any of such organizations, trades, or businesses.
• In the case of any transfer (or license) of intangible
property the income with respect to such transfer
or license shall be commensurate with the income
attributable to the intangible.
Treasury Regulation §1.482

• Section 482 of the Internal Revenue Code (IRC)
– Reaffirms the arm’s-length standard
– Establishes that there is a range of arm’s-length
prices
– Establishes the “best method rule”
– Distinguishes product comparability from
functional comparability
U.S. Regulations Addressing Transfer Pricing

• Section 6662 of IRC -- Issued Feb. 1996
– Requires documentation which:
• Demonstrates an arm’s-length result
• Justifies the use of a “best method”
• Outlines pricing policies
• Describes international operations
U.S. Regulations Addressing Transfer Pricing
(cont.)

OECD guidelines

• The main objective of the OECD is to promote policies that will
improve the economic and social well-being of people around
the world. The OECD provides a forum in which governments
can work together to share experiences and seek solutions to
common problems.
• Contribute to international commerce in a multilateral, non-
discriminatory basis.
• Provide member countries with transfer pricing guidelines;
however, these are non-binding guidelines and may be
overridden by domestic law.
Organization for Economic Cooperation
and Development (OECD)

• OECD Transfer Pricing Guidelines
– Part I: Principles and Methods
– Part II: Applications
• Revision of the Guidelines presented in 1979
• Part I issued and approved by OECD Council in July 1995
• Part II approved by OECD Council in March 1996
OECD Guidelines: Part I and Part II

• Reduce incidence of double taxation
• Do not override domestic law
• Do not bind OECD members: limited acceptance
• Framework for international cooperation
• Framework for development: conformity
The OECD Revised Transfer Pricing
Guidelines

• Covers transfers of tangible property
• Reconfirmation of arm’s length principle
• Review and approval of transaction methods
– Comparable Uncontrolled Price (“CUP”)
– Resale Price (“RPM”)
– Cost Plus
• Review and approval of profit methods (Profit Split and
Comparable Profits Method)
Part I
OECD Transfer Pricing Guidelines

• Profit Split
• Transactional Net Margin Method (TNMM)
– Similar to the Comparable Profits Method (CPM)
– Examines net margin for controlled transaction
– Applied in manner consistent with Resale Price
Method (RPM) and Cost Plus Method
– Uses comparable uncontrolled transactions with
no comparison of global profit
Part I
Profit Methods

• Burden of proof
– problem of divergent rules between countries
– both taxpayer/tax authority should be prepared to make
good faith showing regardless of burden of proof
• Penalties
– sizable “no fault” penalties considered unduly harsh
• Simultaneous tax examinations recommended
• Advanced Pricing Arrangements (“APAs”) approved
– strong emphasis on bilateral agreements
• Safe harbors rejected
Part I
Recommended Compliance Practices

Comparison of US transfer pricing to the
OECD transfer pricing guidelines

Comparison - Methods

• There is significant similarity between the OECD methods
and the US methods, with as main exception the Services
Cost Method (SCM). SCM is an elective method allowing
taxpayers to charge out services at cost if the services are
either on a list of routine and non-core services published
by the IRS (e.g. HR, tax, legal, AP/AR services), or if they
have a median comparable markup of 7% or less. These
are referred to as covered services. Taxpayers must also
determine that these services do not contribute significantly
to key competitive advantages, core capabilities, or
fundamental risks of success or failure in their business.
Comparison – Methods (cont.)

Puerto Rico regulation

• In any case of two or more organizations, trades, or
businesses, whether or not incorporated, whether or not
organized in Puerto Rico, and whether or not affiliated,
owned or controlled directly or indirectly by the same
interests, the Secretary is authorized to distribute, apportion,
or allocate gross income and deductions, credits, or
allowances between or among such organizations, trades,
or businesses, if he determines that such distribution,
apportionment, or allocation is necessary in order to prevent
evasion of taxes or to clearly reflect the income of any of
such organizations, trades, or businesses.
2011-PRIRC §1040.09 - Allocation of income and
deductions

• The Secretary is also authorized to impute income by
reason of interest, dividends, compensation or for any
other concept or nature in transactions, trades or
businesses when it is necessary to avoid tax evasion or
to clearly reflect the income of any of such
organizations, trades or businesses.
2011-PRIRC §1040.09 - Allocation of income and
deductions (cont.)

• Articles 1040.09-1 to 1040.09-22
• Will effectively grant Puerto Rico businesses with
official Transfer Pricing guidelines
Proposed – Regulation 8049

• Current version presents a mix of guidelines from:
– US Treasury Regulations
– OECD Transfer Pricing Guidelines
• Only technical guidelines available.
– No administrative procedures
– No filing or evidence requirements yet
• Current version states it will apply to controlled organizations
in which at least one member of the group is:
– A large taxpayer (section 1010.01 (a)(35), or
– In the previous year had gross sales volume or average
assets of $10M or more.
Proposed – Regulation 8049 (cont.)

• The Secretary has the authority to request a transfer pricing
study to other taxpayers below the established threshold
• Control for transfer pricing purposes is a much wider
concept than for income tax
• Regulation is not tied to 51% disallowance provision in the
law
• Time table:
– will be sent for signature to Department of State by
December 19th
– will not be effective until administrative provisions are
published
Proposed – Regulation 8049 (cont.)

The transfer pricing study

• Determines compliance of intercompany pricing
policies with local country regulations
• Review and analysis of a company’s current pricing
of intercompany transfers of tangible property,
services, or intangibles
• Establishment of a policy, support of a current policy,
or proposal of changes in current policy
• Establishes transfer pricing policies that can benefit
corporate planning by determining a company’s
worldwide tax liability
Transfer Pricing Studies Types -
Transfer Pricing Study

• The purpose of benchmarking studies is to
determine the general conditions surrounding the
transactions conducted by third parties on a given
market. Such studies help elicit a range of values,
i.e. the so-called arm's length range or mark-up
range.
Transfer Pricing Studies Types -
Benchmarking Study

• Statement of Facts and Functional Analysis
– Industry Overview
– Overview of the Company and it’s Role in the
Industry
– Discussion of Relevant Company Operations -
Functions Performed, Risks Borne, and Assets
Employed
– Description of Organizational Structure for Relevant
Entities
– Overview of the Subject Intercompany Transactions
Components of a Transfer Pricing Study

• Economic Analysis
– Restatement of the Subject Intercompany Transaction
– Overview of Relevant Regulations
– Description of Method Selection/Rejection
– Description of Analysis Performed
• Application of Regulatory Tests
• Selection of Tested Party and Years of Comparison
• Selection of Comparable Companies / Comparable
Transactions
• Step-by-Step Detailed Discussion of Analysis Performed
– Statement of the Results of the Analysis
Components of a Transfer Pricing Study (cont.)

Base erosion and profit shifting
(BEPS)

• On October 5, 2015, the OECD issued its final
reports on the 15 focus areas identified in its Action
Plan on BEPS. These were discussed and
endorsed at the G20 Finance Ministers' meeting on
October 8, 2015.
• The recommendations range from new minimum
standards to reinforced international standards to
common approaches and best practices.
BEPS

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