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Puerto Rico: Can Washington Do Anything to Help? Joseph Engelhard Senior Vice President Joseph.Engelhard@capalphadc.com (202) 548-0445 January 2014

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Key Takeaways

Puerto Rico: Can Washington Do Anything to Help?

• While the U.S. can distinguish federal assistance to Puerto Rico (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. • In Washington, there is a general awareness that PR is at increasing risk of a downgrade. The biggest concern is that fire sales of its $70 billion in municipal debt could 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. • 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 coordinating 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. © 2013 Capital Alpha Partners, LLC. All rights reserved.

How Puerto Rico is Different

Puerto Rico’s Special Status as a Commonwealth •  All residents are U.S. citizens •  However, for tax purposes, treated as a foreign country •  Don’t pay federal or state taxes •  Eligible for some U.S. benefits, but not all and not at same level Legal and Political Differences •  Legally, U.S. could provide special tax benefits to a Commonwealth, which would in effect only be benefitting PR •  Politically, it is easier to support as its GDP per capital and poverty levels are lower than all U.S. states ($24,451 GDP per capita and 41% below poverty line) However, Level of U.S. Assistance Already High •  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

Washington Wants to Help But Limited Potential for Now Current Spending and Tax Environment is Very Challenging •  Recent budget debates and government shutdowns following 2008 crisis •  PR has a long history of special provisions and support, including the ARRA and ACA implementation, but much harder now •  Eligible for some U.S. benefits, but not all and not at same level • Until Recently, Concerns by Key Congressional Leaders about PR Structural Reform •  A key U.S. senator has stated his concern about doing more for PR until it can demonstrate structural reform and implement its growth strategy •  Delegate Pedro Pierluisi issued a statement on Dec. 12, 2013: o  “The García Padilla administration must correct course. A sense of urgency is required, because the stakes could not be higher for Puerto Rico. o  The first step the Governor must take is to acknowledge reality and to stop proclaiming, despite all the evidence to the contrary, that the financial and economic picture is improving.

Federal Support Via Taxes 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. • 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. • Extender legislation might pass later in 2014, but 48% now goes to the rum companies (to avoid more business moving to Virgin Islands). Credit for PR Excise Tax • Governor Luis Fortuño enacted an excise tax for PR manufacturing companies in 2010. Relying on a tax opinion from the law firm Steptoe & Johnson, many of them began using these tax payments as a U.S. 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 raises significant revenue for the commonwealth. A January 2014 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. Potential Challenges • Fundamental tax reform proposals would subject income of U.S. companies to immediate taxation. • At some point, Congress may halt the ability of U.S. companies to claim the PR excise tax as a credit against their U.S. tax obligations.

Appropriations Additional Social Program Support PR residents do not receive all of the same level of benefits in programs such as the refundable Child Tax Credit program, the refundable Earned Income Tax Credit 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. Â Delegate Pierluisi has made additional spending support, as a matter of equality, his top priority. Pierluisi has also criticized many of the previous special tax provisions for PR, arguing that they benefit corporations but not the average citizen. White House Task Force In November 2013, the White House announced a team of U.S. agency representatives would begin to work with PR government to find additional ways for PR to take advantage of existing federal programs. Some examples include making Ponce a special free trade tax zone.

Final Assessment of U.S. Potential Support

Given current levels, we do not expect significant additional support absent a greater sense of urgency. A failed attempt to access capital markets, or a credit rating agency downgrade might spur additional support via the Puerto Rico Working Group or appropriations. However, given the dysfunctional congressional environment, particularly on tax reform, even a crisis may not be sufficient to trigger significant tax support. This is especially true given Delegate Pierluisi s focus on social spending instead of tax breaks for corporations. Finally, the most effective help may actually come from the advice of the White House Puerto Rico Task Force, which is advising PR on how to solidify their fiscal situation and successfully implement structural reform. Ultimately, it will be up to the leadership of the PR government and their ability to pass structural reform and implement their economic growth agenda. To the extent the U.S. sees that happening, it will be easier for additional U.S. support to follow.

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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: Charles Gabriel and Joseph Engelhard." " 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." " © 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."