A tax passed in Puerto Rico on Oct. 25, 2010 has drawn heavy criticism from the medical, pharmaceutical, and biotechnology industries. The levy, they say, could harm innovation and could hinder those industries on the island, the world’s fifth largest pharmaceutical manufacturing region after the United States, the United Kingdom, Japan, and France.
Known as Law 154, the initial 4% tax on offshore corporations benefiting from island manufacturing was approved by both houses of the Puerto Rican government over a weekend and signed into law by Governor Luis Fortuño on a Monday without public hearings or stakeholder input. Some pharmaceutical manufacturers have already indicated they will postpone the transfer of new product manufacturing to Puerto Rico until they understand the full impact of the legislation.
Sunnier Days ... Behind?
Until Law 154 passed, pharmaceutical manufacturers on La Isla del Encanto (in Spanish, “The island of Enchantment”) benefited from some of the best tax incentives in the world, including no U.S. federal income tax and a local corporate income tax rate not higher than 7%. In contrast, Ireland, another low tax manufacturing region, has a corporate income tax of 12.5%.
U.S. tax incentives played a large role in creating the Puerto Rico pharmaceutical manufacturing powerhouse. Starting in the 1950s, the government of the commonwealth created a series of tax incentives to attract economic development. Eli Lily opened its first plant in the 1960s, followed by Merck and Pfizer, then Abbott Laboratories, AstraZeneca, Bristol-Myers Squibb, GlaxoSmithKline, Johnson & Johnson, Novartis, and Pfizer.
According to Enrique Alejandro, finance committee chair of the Pharmaceutical Industry Association of Puerto Rico (PIAPR), “The companies on the island operate under the same U.S. treasury and judicial system and the same intellectual property protection laws that they would on the mainland. As a territory of the U.S., companies also are subject to federal laws including the U.S. Food and Drug Administration and Environmental Protection Agency guidelines.”
Puerto Rico became home to the majority of major pharmaceutical and medical device manufacturers, boasting some $80 billion in pharmaceutical industry infrastructure spread among 89 FDA-approved pharmaceutical and biopharmaceutical plants. The island is the second largest employer in the life sciences industry with the largest concentration of life sciences industries per square foot in the world. Eight of the top 20 biologics sold in the United States, as well as 13 of the top 20 prescription drugs are manufactured in Puerto Rico.
Economically, the biopharmaceutical and medical device industries represent 28% of the island’s Gross Domestic Product, 34% of all industrial jobs, and 72% of all exports. So, why would Governor Fortuño’s administration put the sector at risk?
The Beginning Of A Crisis
In January 2009, when Governor Fortuño took office — the first Republican governor elected on the island in 40 years — he inherited a $3.5 billion deficit, a 46% budget shortfall, and a credit rating lower than California’s, the worst-rated state according to Standard & Poor’s.
In his first two years in office, Fortuño cut the size of the budget by 20% and is on course to balance the budget by the end of his first term, reducing the deficit to zero in four years. In a document he distributed to the press, he said that in April, Moody’s increased Puerto Rico’s general obligation bond rating by three notches to A3 from Baa3, the highest improvement given to any of the 34 states whose ratings it recalibrated. The week after Law 154 was enacted, Fortuño unveiled a comprehensive plan to dramatically cut Puerto Rico’s corporate and individual tax rates. Designed to create jobs and spur economic development, the tax reduction plan decreases individual rates by 50% and corporate rates by 30%. Part of the tax reform will be financed by Law 154, which is estimated to raise an estimated $5.86 billion over the next six years. The six-year tax would target between 40 and 50 Controlled Foreign Corporations (or CFCs) operating in Puerto Rico that make more than $75 million annually. Scheduled to take effect Jan. 1, 2011, and run through 2016, the measure imposes a tax levy of 4.0% in 2011, 3.75% in 2012, and 2.75% in 2013.
The Puerto Rican government is betting that the tax paid on the island would be creditable against U.S. income tax. However, for a foreign tax credit to be creditable requires a revenue ruling from the IRS, which as of this writing, the Government of Puerto Rico has not requested. In addition, not all CFCs operating in Puerto Rico are U.S.-based, and the future tax credit would not apply to them.
The Pharmaceutical Research and Manufacturers of America (PhRMA) and the Biotechnology Industry Organization (BIO) criticized the new law. In an issued statement, PhRMA President John Castellani said, “Law 154 will dramatically hinder [PhRMA member] companies’ positive efforts within Puerto Rico. The measure imposes special taxes on certain activities and transactions conducted by nonresident individuals and companies in Puerto Rico. This could significantly reduce the ability of PhRMA’s members to operate in the commonwealth and to continue to make significant investments in researching and developing innovative new medicines for patients. In addition, we are concerned that this significant new tax increase was developed and enacted without the opportunity for public input and comment. Transparent and predictable tax policies are critical to helping foster innovation in Puerto Rico.” In a letter to Governor Fortuño, BIO President and CEO Jim Greenwood echoed the criticism, saying, “BIO believes that the proposed foreign company tax provisions [in Law 154] stand to greatly diminish the capacity of innovating and cutting-edge life sciences companies in Puerto Rico. These proposed taxes, however, will not only ensure that Puerto Rico’s ability to attract new business investment will be constrained, but they will also lead to decreased innovation in the established Puerto Rico life sciences sector and possibly even the migration of high-quality and high-wage jobs out of the area.” In an email circulated following the passage of the law, Ivan Lugo, executive director, INDUNIV, a nonprofit organization that works with industry, academia, and government to promote the application of science and technology to Puerto Rico’s pharmaceutical and biotechnology industries referred to the legislation as a “mortal post-936 blow,” citing a section of the Internal Revenue code that was phased out at the end of 2005. According to Lugo, “Between 2002 and 2008, four new biotechnology plants were constructed in Puerto Rico, an investment of more than $4 billion that generated more than 3,500 jobs. Those investments were made because Puerto Rico has been considered a stable place to do business.”
To attract earlier stage companies, the commonwealth had offered a Pioneer Activity income tax between zero and 2% that could last for up to 15 years. Eligibility depends on the types of jobs created, the expertise of the employees that will be hired, and investments made in plants, machinery, and equipment. There are also credits for infrastructure, renewable energy, intangibles, packaging, and a staggering 50% for clinical trials. Companies can claim up to 50% of their costs, a credit that can be sold on the market, used against existing liabilities, or can be passed through to affiliates. Those credits, according to Lugo, are not affected by Law 154.
A Lack Of Transparency
According to Kendra Martello, assistant general counsel, PhRMA, the law’s rapid passage without public and stakeholder input represents a significant problem. Not only because of the lack of transparency, but because of the certainty needed by industries — such as the biopharmaceutical industry – involved in long-term planning. “When you consider the uncertain nature of biopharmaceutical research and the long-range business planning that these companies must engage in, coupled with the fact this law was enacted very quickly, you can see it could have very significant impact on PhRMA member companies,” said Martello. “It also will have a significant impact on the island, where pharmaceutical companies contribute nearly 100,000 high-skilled, high-paying jobs to the local economy. In addition, the tax could have a negative impact on patient access to new and innovative medicines.” Whether the tax will generate the revenue anticipated and its adverse effects on manufacturing remain to be seen. On Nov. 2, 2010, PIAPR asked the governor and his office to postpone the implementation of Law 154 for one year, giving industry time to identify other ways in which it could contribute to his tax reform initiatives without negatively impacting one of the island’s most important economic sectors. According to CaribbeanBusinessPR.com, a Puerto Rican news and information website, Governor Fortuño has been meeting with the executives of companies impacted by Law 154. He claims they are willing to work with him and his administration on solutions around the new law.