2013 01 14 je pr fi

Ja nua r y 14, 2013

Fixed Income Puerto Rico: Can Washington Do Anything to Help?

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Puerto Rico (PR) is at increasing risk of a downgrade, which could lead to fire sales of its $70 billion in municipal debt and trigger a default or contagion in other municipal funds. Despite the efforts of the White House task force, the level of support in Congress and many of the U.S. agencies for additional funding is mixed and therefore will likely only provide marginal additional benefit in the near-term.

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While the U.S. can distinguish federal assistance to PR both legally and politically due to its unique status as a Commonwealth, we view the range of additional direct support to the PR government as limited.

Partly due to the lack of a sense of urgency, and partly due to the administration’s stance that PR is well positioned to handle its debt issues by itself, any significant additional support would be more likely to occur in response to a downgrade.

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The areas where the U.S. could help the most include: extending the higher rum tax, continuing to give U.S. companies tax credits for excise taxes paid to PR, and co-ordinating greater federal spending through the PR task force. Should a downgrade occur, the U.S. is more likely to substantially increase appropriations support, but tax breaks will remain more challenging.

Joseph Engelhard joseph.engelhard@capalphadc.com (202) 548-0445 Charles Gabriel charles.gabriel@capalphadc.com (202) 548-0103 Robert Rose rob.rose@capalphadc.com (202) 548-2540

What Puerto Rico Needs While there are a wide variety of ways that the U.S. federal government can either directly or indirectly increase its support for PR, policies that provide funding directly to the PR government or that spur real economic growth are most essential. The two primary channels are through appropriations bill or through the tax code. PR’s unique status as a commonwealth, and as one of the very poorest regions of the U.S., provide a way to distinguish PR both legally and politically from other U.S. municipalities that might be threatened with default.

The Rum Tax Cover-Over The most significant direct revenue support comes from the U.S. rum tax cover-over program, whereby the U.S. turns over all but 25 cents of the $13.50 average per gallon tariff in recent years to the PR government.

However, failure to pass what is known as the “tax extenders” legislation in 2013 means that as of January 2014 the rum tax has been reduced to $10.50.

That represents about a 22% drop in the rate. In recent years, the U.S. has passed on to PR about $450 million in “cover-over” rum revenue.

The fate of the additional rum tax is tied to that of the larger question of whether and when Congress can agree to extend the R&D and other tax extenders legislation. For many years, these tax provisions have been routinely passed in Congress, but the current divisions over budget and 600 Pennsylvania Avenue SE - Suite 220 - Washington, DC 20003 www.capalphadc.com

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spending have made it very difficult to pass almost any reasonable, bipartisan agreements.

While inclusion of a higher rum tax is possible if and when Congress agrees to pass the traditional tax extenders legislation sometime later in 2014, it is by no means certain. But retroactive passage would result in possibly around $100 million in additional revenue for the PR government. However, that figure must be further reduced when you take into account the recent agreement between the PR government and rum producers to reimburse 48% of that revenue back to the rum producers themselves. This agreement was necessary to avoid the rum producers from leaving to the Virgin Islands, where a similar tax benefit is open to them.

The Excise Tax From 1976 to 1996, the U.S. provided a federal tax credit for manufacturing that generated significant job and economic growth in PR, largely in the pharmaceutical and life sciences sector. In the aftermath of Congress repealing the tax credit, then Governor Governor Luis Fortuño enacted an excise tax in 2010. Relying on a tax opinion from the law firm Steptoe & Johnson, many of the same manufacturing companies that benefited from the now repealed section 936 IRS code could now claim these tax payments as a reduction in federal revenue or even as a tax credit. Despite misgivings in Congress, the U.S. Treasury and the IRS have not challenged this opinion.

This is likely one of the most significant tax benefits for companies located in PR, and it also raises significant revenue for the commonwealth. A January press release from the PR government indicated it increased collections from foreign companies via a four percent tax increase, resulting in $177 million for 2013, $61 million (53%) more than last year.

White House Puerto Rico Task Force In November 2013, the White House announced a team of experts from the Administration would begin to work with PR government officials in order to help PR further address economic issues by using existing federal resources. The team complements the current efforts of the President’s Task Force on PR, which aims to strengthen PR’s fiscal situation and develop growth strategies. In our view, both the PR government and U.S. officials are taking the threat of a downgrade and potential default more seriously, which is a helpful development. While not sufficient in itself, recognition by key officials in the U.S. and San Juan is an important first step.

The Task Force has been working with PR’s leadership on economic development and the management of federal funds since 2009. Much of the advice provided to the PR government will never be made public, but the recent tax and other changes in PR in the last few months are likely the result of the efforts of their work. The recent successes will help as the Task Force reports back on progress being made as it consults with the President and Congress on initiatives that would help spur improvements in PR’s economy.

The team of experts includes members of García-Padilla’s Administration and federal experts from the Department of Education, the Department of 2 © 2013 Capital Alpha Partners, LLC 600 Pennsylvania Avenue SE - Suite 220 - Washington, DC 20003 www.capalphadc.com

Health and Human Services, the Department of Housing and Urban Development, and the Environmental Protection Agency. Professional staff from the Office of Management and Budget, the National Economic Council, the Council of Economic Advisors and the Department of the Treasury are also part of the team, and they are likely very active in advising on treasury management, tax collection and growth initiatives.

The Limits of Benefits to Puerto Rico U.S. Federal Assistance Already at High Levels In 2012, the U.S. provided just over 21% of PR’s around $100 billion economy. Close to one-third of the Island’s 3.6 million citizens received food stamps and/or other nutritional assistance benefits worth about $2.2 billion.

Islanders are also eligible for social security, disability, Section 8 housing, Medicare, Medicaid, Head Start and other assistance.

Puerto Ricans are full U.S. citizens, but they do not pay federal or state income tax nor do they receive all of the same level of benefits in programs such as the refundable Child Tax Credit (CTC) program, the refundable Earned Income Tax Credit (EITC) program, Medicare, the Temporary Assistance for Needy Families program, Supplemental Security Income, and Medicaid. Should Congress ever decide that additional support for PR is a priority, they could make Puerto Ricans eligible for greater access or levels of support in these federal programs. Given the high levels of poverty on the island, and in the context of a potential default threat (perhaps subsequent to a downgrade) some greater assistance is likely.

Attitudes in Congress Vary Some key members of Congress, including those in New York, where many Puerto Ricans have emigrated are ambivalent regarding PR. One Senator in particular has indicated his view that the PR government has not made enough effort to implement structural reforms and is thus reluctant to push for more benefits for PR. Others, such as PR Delegate Pedro Pierluisi, have shifted away from arguing for more tax benefits for pharmaceutical companies and other life sciences companies (which are a key element of the PR government’s strategic plan), and instead is seeking additional benefits for individual citizens in PR. Pierluisi has prioritized “equal treatment” for PR citizens under the refundable Child Tax Credit (CTC) program, the refundable Earned Income Tax Credit (EITC) program, Medicare, the Temporary Assistance for Needy Families program, Supplemental Security Income, and Medicaid.

These programs have the potential to indirectly assist PR’s struggling economy. In 2006, the Joint Taxation Committee estimated the equal treatment of PR under CTC would inject $180 million into PR’s economy and the EITC would provide $520 million a year to low-income Puerto Ricans. (See list of proposed bills below for more details.)

In addition, Pierulisi recently suggested a number of changes to the recent fundamental tax reform proposals from both the Senate Finance Committee 3 © 2013 Capital Alpha Partners, LLC 600 Pennsylvania Avenue SE - Suite 220 - Washington, DC 20003 www.capalphadc.com

(chaired by Democrat Senator Max Baucus) and the House Ways & Means Committee (chaired by Republican Representative David Camp) that would require immediate taxation of income in PR (currently it is being treated as foreign source income, and therefore not taxable in some cases until the parent repatriates any revenues to a U.S. parent company). Again, this is an indication of how concerns about PR’s economic condition are not sufficient for either a key Democrat Senator or a Republican House Member to provide an exception (as requested by the current PR governor). Nor have they been too receptive so far to the suggested alternatives proposed by Delegate Perluisi.

Additional Background Information on U.S. Federal Measures that Could Benefit Puerto Rico Rum Tax Cover-Over Program Under U.S. law there is an excise tax on rum produced in or imported in the U.S dating back to 1917. In 2013, the excise tax was $13.50 per proof gallon with $13.25 per proof gallon of imported rum that is produced in PR and the U.S. Virgin Islands (USVI) and sold in the 50 states transferred or “covered-over” to PR and USVI according to the market share of rum each territory produces. In FY2011, PR received over $449 million in revenue and the USVI received over $133.5 million.

Despite legislation introduced during the last Congress to expand federal control over the use of covered-over revenue, both U.S. territories are able to use the revenue for their own purposes, such as economic development and promotion of the rum industry.

While temporary increases in the limit on cover-over rum excise taxes have been routinely extended in the past, Congress failed to re-extend the cover over increase alongside a bundle of other tax breaks afforded by the American Taxpayer Relief Act of 2012 (PL 11-240), which expired on January 1, 2014.

Unless Congress acts to re-extend the increase, only $10.50 of the $13.50 per gallon will be transferred over to PR and USVI this year. Last December, Sen. Harry Reid (D-NV) introduced legislation including a temporary oneyear extension of the cover-over increase, however no major actions have been taken and the future of the cover-over increase remains unclear.

Puerto Rico Excise Tax In 1976, a federal credit that offset tax on income attributed to PR, U.S. Internal Revenue Code Section 936, was signed into law to encourage job creation in PR. Despite being very successful in creating many jobs in one of the poorest regions of the U.S., in 1996 Congress repealed 936 due to a wideheld Congressional view that it was unfair to tax companies manufacturing in a U.S. territory less than those manufacturing in the U.S. As well, companies used 936 to avoid taxation for work performed in the U.S., by attributing income to PR, which many in Congress believed to be a perversion of 936’s original intent that also denied the federal government significant revenue.

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In 2010, former Governor Louis G. Fortuño signed into law regulations that modified PR tax law by adopting new source-of income rules and imposing a temporary six-year excise tax on particular purchases by offshore companies with manufacturing operations in PR whose gross receipts exceed $75 million. The excise tax rate amounted to 4% in 2011 and was designed to gradually scale down to 1% by the end of the six years. In addition, these regulations included provisions that allowed for general credits against the excise tax that could provide partial relief or entirely offset the excise tax burden in particular circumstances. One of PR’s largest industry groups operating on the island, pharmaceutical, life science and medical device companies, are significantly impacted by the excise tax.

An earlier estimate determined that these regulations could potentially raise $5.8 billion over the term of the regulations beginning on January 1, 2011.

Soon thereafter the IRS issued guidance stating: “The IRS and the Treasury Department are evaluating the Excise Tax. The provisions of the Excise Tax are novel. The determination of the credibility of the Excise Tax requires the resolution of a number of legal and factual issues. Pending the resolution of these issues, the IRS will not challenge a taxpayer’s position that the Excise Tax is a tax in lieu of an income tax under section 903.” In our view, it is unlikely that the U.S. Treasury or the IRS will challenge U.S. companies reliance on the Steptoe & Johnson advisory letter.

This fiscal year, Governor Alejandro García-Padilla signed legislation to set the excise tax at 4% for periods starting after December 31, 2012 to December 31, 2017. The Administration argued that such legislation extending the excise tax is crucial in order to help further stabilize PR’s public finance issues.

Puerto Rico Aims to Spur Economic Development with Seaborne Airlines In an effort to spur economic activity, PR economic development bank invested $9 million dollars in Seaborne Airlines during late 2013 prompting the airline to move its headquarters to PR by March of this year. The investment provides PR with a 20 percent ownership of the airline through preferred stock and affords PR two seats on the board of directors of its parent company, Coastal International Airways. Seaborne expects to create 400 new jobs in PR, with 150 of those jobs added in the first quarter of 2014. In response to the recent departure of American Eagle from the Caribbean market, Seaborne will add new routes around the Caribbean that are important to PR’s tourism industry. The García Padilla Administration expects the airline’s move to prompt $32 million in economic activity in 2014 and $86 million in 2015. García Padilla said, “This partnership is important for reconnecting PR to the Caribbean islands and also is an investment in jobs, commerce, new business opportunities and economic development.”

Pierluisi Proposes Alternative Tax Treatment for Puerto Rico Last week, Congressman Pedro Pierluisi (D-PR-At Large) sent proposals to the Senate Finance and House Way and Means Committees regarding alternative federal tax treatment for PR. Pierluisi argued that tax reform should help PR and suggested the following modifications to the base erosion provisions: 5 © 2013 Capital Alpha Partners, LLC 600 Pennsylvania Avenue SE - Suite 220 - Washington, DC 20003 www.capalphadc.com

“Until the expiration of the multi-year tax reduction agreements that are in place at the time of the enactment of federal tax reform legislation, any revenue raised as a result of the application of base erosion provisions to business activities in PR would be granted by the U.S. government to the territory of the government.

Congress should place reasonable conditions on the granted revenue, requiring that such revenue be used by the PR government for specified public purposes, such as initiatives to reduce the cost of electricity and water, improving the public education system, enhancing public safety, and reducing public debt.”

While Pierluisi’s proposals would replace the current system that permits companies in the U.S. to defer paying corporate income taxes by establishing foreign subsidiaries in the U.S. territories, including PR, such companies are not required to pay the 35% income tax until they have legal ownership of the subsidiaries’ earnings.

Senate Finance Committee Chairman Max Baucus (D-MT) and House Finance Committee Chairman David Camp (R-MI-04) support immediate taxation of such income. Camp’s proposal would tax income earned from patents and trademarks developed in the U.S. at a corporate tax rate of 25% for those sold in the U.S., 15% for those sold abroad, and additional income at 1.25%. Baucus’s legislation would tax income from goods or sales in the U.S. at a new unspecified alternative corporate tax rate, which some expect to be around 28%. Multiple options have been floated for products destined for foreign markets with one at 80% of the new rate and another at 60%.

While Garcílla Padilla sought exemptions for PR income from such taxes, Camp and Baucus have not agreed with Garcílla Padilla’s proposal, however, Baucus has requested comments regarding appropriate taxation of such subsidiaries.

Proposed Bills H.R.2838 — 113th Congress (2013-2014) Puerto Rico Interstate Commerce Improvement Act of 2013 Sponsor: Cosponsors: Latest Action:

Rep. Pierluisi, Pedro R. [D-PR-At Large] (Introduced 07/25/2013) 0 07/26/2013 Referred to the Subcommittee on Coast Guard and Maritime Transportation.

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H.R.364 — 113th Congress (2013-2014) Supplemental Security Income Equality Act Sponsor:

Rep. Pierluisi, Pedro R. [D-PR-At Large] (Introduced 01/23/2013)

Cosponsors:

5

Latest Action:

02/04/2013 Referred to the Subcommittee on Human Resources.

H.R.670 — 113th Congress (2013-2014) Puerto Rico Medicare Part B Equity Act of 2013 Sponsor:

Rep. Pierluisi, Pedro R. [D-PR-At Large] (Introduced 02/13/2013)

Cosponsors:

12

Latest Action:

02/19/2013 Referred to the Subcommittee on Health

H.R.2000 — 113th Congress (2013-2014) Puerto Rico Status Resolution Act Sponsor:

Rep. Pierluisi, Pedro R. [D-PR-At Large] (Introduced 05/15/2013)

Cosponsors:

129

Latest Action:

05/15/2013 Referred to House Natural Resources

H.R.365 — 113th Congress (2013-2014) Territorial TANF Equity Act of 2013 Sponsor: Cosponsors: Latest Action:

Rep. Pierluisi, Pedro R. [D-PR-At Large] (Introduced 01/23/2013) 4 02/04/2013 Referred to the Subcommittee on Human Resources.

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Additional Information White House Puerto Rico Task Force Report Letter from Delegate Pierluisi to Co-chairs of President's Task Force on Puerto Rico

Analyst Certification The following analysts hereby certify (1) that their views about any and all of the subject companies and securities discussed in this report are accurately expressed and (2) that no part of their compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed in this report: Joseph Engelhard, Charles Gabriel, and Rob Rose.

Important Disclosures This publication is for private circulation and distribution in its entirety; it is provided to you for information purposes only. This is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. Capital Alpha Partners, LLC makes every effort to use reliable, comprehensive information, but we do not represent or warrant that it is accurate or complete. The views in this publication are those of Capital Alpha Partners, LLC and are subject to change without notice. Capital Alpha Partners, LLC has no obligation to update its opinions or the information in this publication. Neither Capital Alpha Partners, LLC, nor any respective officers, directors, partners, employees, or affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. Analysts may own securities of the issuers discussed herein. Š Copyright Capital Alpha Partners, LLC (2013). All rights reserved. No part of this publication may be reproduced, sold, or redistributed without the prior written permission of Capital Alpha Partners, LLC.

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