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Executive Summary

SECTION 936 PUERTO RICO TAX CREDITS WOULD BE PHASED OUT over a six-year period under legislation currently pending before the Senate Finance Committee. The bill, S 712, would provide for a referendum in 1991 in which citizens of Puerto Rico could vote for statehood, independence or to retain its commonwealth status. The legislation already has been reported out of the Senate Energy and Natural Resources Committee. As amended by the Energy Committee, the bill sets up a transition schedule for tax credits allowed to U.S. businesses investing in Puerto Rico under Section 936 of the tax code in the event that Puerto Rico votes for statehood. Under the bill, the 936 tax credit would be continued for six years, through 1997, but would be phased out gradually over the last four years of that period. Specifically, "income or investments from activity in Puerto Rico shall be reduced to 80% for taxable years beginning in 1994," the Energy Committee report says, "60% for taxable years beginning in 1995, 40% for taxable years beginning in 1996, 20% for taxable years beginning in 1997" and a cessation of credits thereafter. Treasury Department Assistant Secretary Kenneth Gideon testified at a Nov. 14 Finance Committee hearing that the department accepts the proposed phase-out as a "sensible approach," but notes that the plan may create a bias toward keeping commonwealth status. If Puerto Rico votes to remain a commonwealth, no changes would be made to Section 936 credits. Gideon pointed out that employment in the "936 companies now accounts for about 12% of total Puerto Rican employment." He noted that "a phase-out of Section 936 benefits would probably cause some economic dislocation on Puerto Rico, at least in the short run." If the country votes for independence, the tax credit would cease immediately. Another alternative would be a uniform phase-out of Section 936 under both the statehood and commonwealth options, Gideon said. "Nevertheless, we recognize that Section 936 cannot be viewed in isolation from the other costs and benefits affected by this referendum, and we seek an opportunity for the Puerto Rican people to make a fundamental decision about their political future, not a straw poll on the relative tax benefits," he added. Justice Department Assistant Attorney General Shirley Peterson told the committee that the department believes that the constitutionality of the bill's tax provisions would be upheld by the courts. The question arises under the tax uniformity clause of the Constitution, which provides that all taxes imposed by Congress "shall be uniform throughout the United States." The purpose of the clause is to prevent unfair "preference" of one state or states over another. However, "the exercise of the taxing power by a Congress composed of representatives of 50 states to grant temporary tax benefits to the 51st state entering the Union hardly qualifies as the oppression the Tax Uniformity Clause was designed to prevent," Peterson said. The attorney also noted two legal precedents in which the Supreme Court held that "classifications framed in geographical terms could, in certain circumstances, survive challenge under the uniformity clauses." In other words, in certain cases, Congress can "frame tax legislation in geographic terms in response to a geographically isolated problem." Peterson added: "We believe that the retention of the Section 936 preference as a transitional measure could, if supported by adequate Congressional findings, be justified as taking into account problems unique to Puerto Rico -- particularly the economic dislocation that would result to an already economically depressed state from a sudden and immediate termination of the Section 936 benefits."

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