(Bloomberg Opinion) -- Puerto Rico might be the new Florida for hedge funds. But should the island want that?
Throughout the Covid-19 pandemic, titans of the investing world have made clear that they’re not wedded to New York City, the financial capital of the world. By and large, they’ve targeted Florida, which boasts warm weather and, crucially, no state income tax. Goldman Sachs Group Inc. in December was considering a new hub in the Sunshine State to house its asset-management division; Steve Cohen’s Point72 Asset Management said in January that it would open an office in West Palm Beach; Dan Sundheim, who runs the $20 billion D1 Capital Partners, decided in March to open an office in Miami; and just in the past month, Bloomberg News reported that both Apollo Global Management Inc. and Millennium Management would set up more offices in Florida.
However, some hedge funds are starting to realize the best tax haven might just be a four-hour plane ride southeast of Miami in Puerto Rico. Bloomberg’s Miles Weiss and Jim Wyss reported that ExodusPoint Capital Management and Millennium have established subsidiaries on the island, aiming to take advantage of legislation from 2012 known as the “Act to Promote the Relocation of Individual Investors to Puerto Rico.” As it stands, at least for the next 15 years, money managers can effectively dodge U.S. taxes on capital gains and even performance fees as long as they’re considered by the Internal Revenue Service to be a “bona fide resident of Puerto Rico” and it’s considered “Puerto Rican source income.”
Obviously, this is an appealing option for superstar fund managers when President Joe Biden is considering a sharp increase in the capital gains tax rate to 39.6% from 20% for both singles and joint filers who make $1 million or more. But what about for Puerto Rico, which remains mired in bankruptcy and whose population has steadily declined over the past two decades?
Puerto Rico’s rationale for the law was flimsy in 2012, and, given its downward economic spiral in the following years, doesn’t look much better in hindsight. Here’s the wording in the English version of the act:
Even when their investment income is exempt from taxation in Puerto Rico, their presence in the Island shall contribute to our economy, because they acquire goods, products, services, and housing, among others. Moreover, the income earned by said individuals, other than their investment income, such as income earned on account of wages or rendered professional services, shall be subject to taxation in Puerto Rico.
Suffice it to say, sophisticated fund managers uprooting their lives from New York or California to Puerto Rico aren’t doing so just to be saddled with large tax bills from the commonwealth. As for housing, it shouldn’t come as much of a surprise that on an island where more than 40% of the population is in poverty, the wealthiest are choosing to cluster together. In the case of Puerto Rico, one such area is Dorado, which is slightly west of the capital San Juan and described as “family-friendly, has high-end housing and is one of the few places with the infrastructure finance professionals need to tap into their employers’ computer networks on the mainland.” Yes, there are art museums and restaurants that cater to the wealthy, but those have been around for years, and they haven’t created enduring prosperity for Puerto Rico. It would seem as if a few more hedge funds wouldn’t tip the scales.
And yet early indications from the bond market suggest that investors see the potential renewed interest in Puerto Rico as a sign the commonwealth will bounce back even stronger from its bankruptcy. A large block of its general-obligation debt issued in 2014 traded Monday at 81.125 cents on the dollar, the highest price since June 2015, just before the governor at the time, Alejandro Garcia Padilla, called the island’s debt unpayable. An unusually large amount of commonwealth bonds sold in 2011 and maturing in 2036 traded hands at more than 80 cents on the dollar, the highest since 2013.
While it’s too soon to say definitively that the prospect of an influx of the ultra-rich is behind the move — the commonwealth is also benefiting from general-fund revenue collections exceeding estimates by more than $1 billion and projections of a cumulative surplus of $15.2 billion through 2035 — it will be worth watching to see whether the securities continue to trade higher. More than 1,000 applications for the individual investors tax incentive, as well as the Export Services Act, were filed during the six months through March, compared with about 3,500 during the previous two fiscal years.
It’s certainly possible that the rise of remote work during the pandemic has made permanently setting up shop on a Caribbean island a less fantastical proposition, and thus portfolio managers will take a hard look at relocating from Manhattan skyscrapers to a tropical climate. However, the more pressing question for Puerto Rico — as it was several years ago — is how to prevent a “brain drain” of well-educated Puerto Ricans leaving the commonwealth for opportunities on the mainland. Is bringing in a handful of multimillionaires or billionaires enough to offset the thousands that are leaving the island each year?
Matt Fabian, a partner at Municipal Market Analytics, is skeptical. “What Puerto Rico needs is tax revenue generated by Puerto Rican companies and individuals from activity in Puerto Rico,” he said. “Bringing in mainland or foreign dollars via tax incentives is never going to be a sustainable, long-term strategy.”
Obviously, Puerto Rico should welcome all hedge fund managers who are coming in under its 2012 law and encourage them to spend locally and invest in their communities. But as the commonwealth looks to emerge stronger from its four-year bankruptcy, its leaders shouldn’t be distracted by catering to these flashy, tax-dodging newcomers who could always bolt for greener pastures. The island’s future depends on reversing the conditions that led it into court protection in the first place. Its current fiscal plan is a good start, as it includes improvements to K-12 education, knocks down barriers to start a business and makes electricity more reliable.
Failure to make headway on these initiatives, however, could leave the island with a deficit as soon as fiscal 2023. With a backlog of at least seven months for applications to qualify for tax breaks, it’s unlikely that fund managers will swoop in to make up the difference in time. A better-managed government and organic long-term economic growth will do more to rebuild Puerto Rico than any amount of Wall Street money ever could.
Per the IRS: "If you're a bona fide resident of Puerto Rico during theentiretax year, you generally aren't required to file a U.S. federal income tax return if your only income is from sources within Puerto Rico. However, if you also have income from sources outside of Puerto Rico, including from U.S. sources, you're required to file a U.S. federal income tax return if such amount is above the U.S. filing threshold. Nevertheless, a bona fide resident of Puerto Rico with a U.S. filing obligation, generally won't report Puerto Rican source income on a U.S. income tax return."
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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