2022-12-02
If an individual owns certain property prior to becoming a bona fide resident of Puerto Rico (“tainted property”), Treas. Reg. §1.937-2(f)(1)(i) generally treats gain on the disposition of the tainted property as not Puerto Rican-source income.
Treas. Reg. §1.937-2(j) says that the rules of Code §318(a)(2) apply for purposes of Treas. Reg. §1.937-2. Code §318(a)(2)(A) says that stock owned by a partnership is considered as owned proportionately by its partners.
If a partnership owns stock prior to a partner becoming a bona fide resident of Puerto Rico (a “BFR of PR”), under Code §318(a)(2)(A) the partner is considered as proportionately owning that stock prior to the partner becoming a BFR of PR.
If the partnership sells the stock, the gain is sourced at the partner level under Code §865(i)(5).
The partner needs to determine the source of the gain on the stock (property that the partner was considered as owning prior to becoming a BFR of PR).
On its face, it would seem that the stock would be tainted property and that (f)(1)(i) would apply to generally treat the gain as not Puerto Rican-source income.
An Argument That Code §318(a)(2) Does Not Apply to (f)(1)(i)
An argument is made that Code §318(a)(2) does not apply for purposes of (f)(1)(i).
The argument says that if (f)(1)(i) applied to assets held through an entity (i.e., indirectly held assets), then (f)(1)(iv) and (v) would not be needed.
A Concern With That Argument
(f)(1)(v) applies if 10% of the value of an entity is owned. (f)(1)(iv) and (v) don’t distinguish between partnerships and corporations. The 10% of value rule applies to both partnerships and corporations.
In contrast, Code §318(a)(2) applies a 50% of value rule for corporations, which is modified to 5% under Treas. Reg. §1.937-2(j). For partnerships, any ownership triggers attribution under Code §318(a)(2).
Applying a 10% of value rule in (f)(1)(v) would suggest that Code §318(a)(2) does not apply to (f)(1)(v).
Code §318 only applies to stock. Perhaps the drafters of the regulations meant for Code §318(a)(2) to apply to stock under the primary rule of (f)(1)(i), but added (f)(1)(iv) and (v) to create an anti-abuse rule for assets other than stock.
When read in this way, it would explain why the Code §318(a)(2) percentage thresholds are not used in (f)(1)(v). This interpretation would also undermine the argument that (f)(1)(iv) and (v) would not be needed if Code §318(a)(2) applies to (f)(1)(i).