The Puerto Rican indirect tax system has gone through a remarkable number of changes during the last 10 years. Back in 2004, the expansion of the fiscal deficit of the Commonwealth and the cities of Puerto Rico started to become unbearable for the government and a serious source of concern for the international bond market. At that time, the annual deficit of the island was around 1 billion dollars and the accumulated deficit was more than 12 billion dollars. The main source of indirect tax revenues for the Commonwealth was an old fashioned, easy-to-avoid excise tax applied at import/manufacturing levels, plus a number of small taxes applied at both the municipal and state level. 2005 – Initial Implementation of Municipal Sales Tax To compensate for the shortage of revenues from the Commonwealth, some municipalities of the island started to implement individual sales and use taxes modeled on the sales tax laws for the state of Florida. On July 1, 2005 the city of Caguas became the first municipality to implement a sales tax on goods and a few services in Puerto Rico at a rate of 1%. In spite of the constitutional challenges made by the business community, the Caguas tax experiment became a complete success in revenue terms. More than $700,000 a month collected by Caguas convinced the other municipalities that a sales tax should stay and be used as a model going forward. In fact, just six months later, a third of the island cities had municipal sales taxes, most of them carbon copying the tax ordinances issued by Caguas. However, most of the personnel of those municipalities barely knew how to implement such a tax. Essential sales tax concepts, other than the tax rate and the tax base, were mostly foreign to the majority of tax officials who basically relied on an external tax advisor to interpret the local tax ordinances. Even the returns issued to collect the taxes in some municipalities had incongruences that led to a great deal of confusion among taxpayers and tax officials. To make the landscape more confusing, the municipalities usually enacted, modified, or revoked their sales taxes via ordinances that were barely available to the general public when published. 2006 – Introduction of Commonwealth-wide Sales Tax The Puerto Rican tax reform of 2006 overhauled the indirect tax system of the island by introducing a commonwealth level 5.5% sales tax and providing uniformity to the sales taxes imposed by the municipalities of the island. After December 2006, Law 117 established that municipalities could only collect 1% sales tax and were required to uniformly apply the same exemptions as described by the law. Only one exception was made in the law; it became optional for the municipalities to impose sales taxes on food for home consumption. At the Commonwealth level, the newly enacted 5.5% commonwealth tax exempted food for home consumption. That meant that the tax base of the municipal sales tax in Puerto Rico was the same as the sales tax of the municipalities that opted for exempting food. 2006 – Additional Indirect Tax Reforms Also, the tax reform of 2006 provided that Hacienda would be the only entity allowed to interpret the sales tax law and issue the administrative regulations and clarifications intended to administer and interpret that law. The 2006 tax reform also gave the municipalities the option to self-administer their sales tax or leave it to the Treasury Department of Puerto Rico (Hacienda) or to a third party to collect their local taxes. As a condition imposed by Hacienda to collect local taxes was the requirement that municipalities should exempt food for home consumption. It was widely perceived that a local administration was more efficient for collecting the local taxes. There were also complaints about Hacienda delaying the transfer of the collected taxes to the local treasuries. For these reasons, only a handful of municipalities (only 23 of 78 municipalities) opted to allow Hacienda to administer their local sales and use taxes. It is also worth mentioning that from 2006 to 2013 the real municipal tax rate was officially 1.5%, however because of the level of debts of the municipalities, the tax reform of 2006 established as a concession to calm the international creditors that the Commonwealth’s Department of the Treasury would be the entity collecting 0.5% of the municipal sales tax while the local tax authority would be collecting the remaining 1% from the taxpayer. From the prospective of the taxpayer, that created a “de-facto” 1% sales tax at the municipal level for reporting purposes. In spite of all the flow of new resources, the revenue problems of the municipalities of Puerto Rico were far from over. Therefore, after 2013, the sales tax system of Puerto Rico faced even more problems and the local sales taxes were about to go thru even deeper changes. Check back for EVOLUTION OF THE MUNICIPAL SALES AND USE TAXES IN PUERTO RICO (Part II) where we will continue our discussion of the many tax changes taking place in Puerto Rico.