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Puerto Rico: Life After Section 936
Global Finance / October 2000

By Larry Luxner

Up until a few years ago, the little roadside 936 Pub & Grill was doing a brisk business, serving lunch and drinks at the nearby pharmaceutical and garment factories lining Highway 2 in the northern coastal town of Manati.

But now, the greasy joint has faded into history -- along with Section 936 of the Internal Revenue Code, for which the place was named.

Under 936, U.S. companies were exempt from paying federal income tax on profits earned by their Puerto Rican manufacturing subsidiaries. The idea was to generate year-round employment in Puerto Rico, and that it did -- in the late 1980s, nearly 170,000 inhabitants of this U.S. Commonwealth had factory jobs, making everything from brassieres to birth-control pills.

In 1995, however, Congress approved a 10-year phaseout of the tax subsidy, grandfathering in existing companies but denying the benefit to newcomers. The program will die completely on Dec. 31, 2005.

Xavier Romeu, Puerto Rico's secretary of economic development and commerce, doesn't seem too concerned.

"Nothing has taken the place of 936, yet contrary to all the predictions that we were going to lose hundreds of thousands of jobs, the opposite has been true," he told Global Finance in a lengthy telephone interview from San Juan. "We're experiencing another expansion in manufacturing, particularly in high-tech contract manufacturing and R&D."

Romeu, who also oversees the investment promotion agency once known as Fomento and today referred to as Pridco (Puerto Rico Industrial Development Co.), says Hewlett-Packard just announced a $100 million investment. That includes a new R&D division in Aguadilla and the establishment of a computer factory by Solectron that'll employ 2,000 people.

"Federal tax incentives have very little to do with high-tech operations nowadays. Most of these companies are profit centers," said the 35-year-old executive. "They came to Puerto Rico because they were able to shield their profits through 936. They paid no federal taxes. That worked wonders when Puerto Rico was going through a transformation from an agragrian to a manufacturing-based economy. It made a lot of sense. Section 936 served as a sweetener for companies that might not have otherwise been interested."

But other considerations became more important, said Romeu -- like location, labor costs, infrastructure, logistics and training.

Today, brags Romeu, "we have had the best year in the history of Fomento," noting that the agency promoted 29,275 jobs -- the highest number since the agency's creation in 1947.

Not everyone buys those numbers, however.

San Juan lawyer Antonio J. Colorado Jr., the island's former Fomento administrator, secretary of state and resident commissioner in Congress, says Romeu's statistics are meaningless.

"There's no way they can be accurate. Where are the jobs? I don't see them," he says. "This is a crisis as far as manufacturing is concerned. The only reason the companies that are here have stayed here is because they've changed to Controlled Foreign Corporations (CFCs). This is the reality."

Colorado -- a pro-Commonwealth politician who lobbied so heavily to keep the tax incentive that he became known as "Mr. 936" -- says Romeu talks about job promotions over a five-year period, and that only 60% of those jobs actually materialize. He adds that the pro-statehood administration of Governor Pedro Rossello gave Hewlett-Packard a $46 million grant to open its R&D center, noting that "they have no other way to get companies to come here."

Peter Holmes agrees. As executive director of the Washington-based Puerto Rico-USA Foundation, Holmes represents over 50 multinationals with operations in Puerto Rico.

"There has not been any growth in the Puerto Rican manufacturing sector," Holmes says. "There have been no new companies to speak of coming to the island. The companies that were there before the repeal of 936 have been able to maintain their operations, but they're not growing as before, since there are no incentives."

Holmes says the island of 3.9 million inhabitants today has 137,000 manufacturing jobs -- not the 163,000 suggested by Romeu. The difference lies in two methods of calculating employment on the island: the household survey and the establishment survey. The latter is viewed as far more realistic, even though the Rossello government uses the household survey for its statistics.

"A lot of companies indictaed that if 936 were repealed, they'd end up leaving. Some of those companies have in fact left, but most of them have been able to reorganize as CFCs," said Holmes. "Therefore, they are not repatriating any of their profits back to the States."

CFC status is particularly attractive to drugmakers, since they generally have massive capital investments in Puerto Rico as well as international operations. Many of those companies can use Puerto Rico-generated earnings at plants in Costa Rica, the Dominican Republic or Europe, for example.

But it's not helpful to apparel firms that have no operations outside the U.S. and, therefore, no other place to repatriate their profits -- if indeed they're making profits at all.

In fact, President Clinton's recent signing into law of the new Caribbean Basin Trade Partnership Act could hurt Puerto Rico in the long run, particularly in low-wage sectors such as mass apparel production and tuna canning.

"Almost all goods are now opened up," said Dr. David E. Lewis, senior associate at Manchester Trade Ltd. in Washington. "The U.S. apparel market has always been the most open market. The difference now will be to what degree the Puerto Rican apparel indsutry has found its niche and is competitive, which is the high-value sector."

Of the island's 1.19 million employees, 258,000 people work in the public sector and 248,000 in services, both far more than manufacturing. Under the 1998 Local Tax Exemption Law, companies pay a flat tax of between 2% and 7%, for terms of 10, 15 or 20 years.

Puerto Rico's perennial status debate is always an issue, and with gubernatorial elections in November, this year is no different. The latest polls give Carlos Pesquera of the pro-statehood New Progressive Party 40% of the vote, followed by 35% for Sila Calderon of the Popular Democratic Party, which favors continued Commonwealth status. Another 7% are solidly behind Ruben Berrios of the Puerto Rican Independence Party, with the remaining 18% of voters undecided.

In the mid-90s, Holmes and his people lobbied hard against the elimination of 936. Yet ironically, it was pro-statehood Rossello who -- knowing that if Puerto Rico became the 51st state it couldn't enjoy federal tax exemption -- suggested that the subsidy was a drain on American taxpayers. That infuriated supporters of Commonwealth status who solidly backed the incentives program.

"Puerto Rico has tried to overcome all that by changing their investment law and making it more attractive, and that's been helpful in maintaining some employment," said Holmes. "We're still working very closely with the government of Puerto Rico to persuade Congress to reverse its attitude and at least continue wage credits beyond the termination date of 2005."

The wage credit is an issue of critical importance, says Holmes. In 1993, Congress enacted legislation that took the former income credit and set up a wage credit, known as 30A, which -- barring some Congressional miracle -- will remain at 60% until its scheduled demise in 2005.

Backing continued benefits for Puerto Rico is the 30A Coalition, an alliance of public and private groups lobbying feverishly for the approval of legislation to expand the credit to include new business, and to eliminate the caps on business income. Most industrialists agree that the federal tax credit is critical to Puerto Rico's economic development.

A letter signed by Rep. Philip M. Crane (R-Ill.), who has introduced a bill offering job opportunities to Puerto Ricans, urges Ways and Means Chairman Bill Archer to include 30A in upcoming tax proposals to help mitigate the impact of another minimum-wage hike on Puerto Rican businesses.

"This increase will have the greatest impact on business in Puerto Rico, because 57% of workers there are within $1.00 of the current minimum wage, far in excess of any other U.S. jurisdiction," the letter states.

Meanwhile, says Lewis, "the push has been away from mass labor manufacturing and more into high-tech services manufacturing. You haven't seen any mass exodus of these companies, but the ones that have relied on cheaper labor have had a hard time."

An example of high-value apparel is Olympic Mills Inc. A new subsidiary of this Puerto Rican company promises to create 1,000 new jobs from the purchase of the sweater-making facilities of Hampshire Group Ltd., the largest sweater company in North America.

Olympic expects to consolidate the Hampshire operations in Puerto Rico. Since 1956, Hampshire has operated Glamourette Fashion Mills Inc., which employs 700 people in Quebradillas in the production of 54,000 sweaters a week. More than $10 million will be invested, says Alejandro G. Asmar, president of Olympic Group. Glamourette plans to expand into nearby Isabela and has a 35,000-square-foot building available.

Meanwhile, BASF Pharmaceutical will invest $30 million to expand its Jayuya operation, building a new industrial complex. The company will hire 100 new workers in the production of a new weight-loss pill called Meridia.

Intelligroup Inc., a global software developer, will open a 23,000-square-foot facility in Trujillo Alto, just outside San Juan, and create 500 engineering jobs over the next three years.

The facility will begin operations by year's end, serving as a "hub for the Americas," said David Olivencia, senior service support manager. Intelligroup, based in India, has operations in Europe, Australia and Asia, reporting annual revenues of $146 million.

Yet these are the exceptions.

"It's been a big back-and-forth as to whether manufacturing is increasing," said Lewis. "The question is, to what degree would 936 have maintained the dynamism that was there, and clearly isn't anymore?

The answer, says the trade expert, is obvious. "In the late 80s, [former Governor] Rafael Hernandez Colon tried to encourage globalization," he said. "But 98% of the island's exports today are to the U.S. What are we doing in Europe? Zilch. Latin America? Nothing. Our economy is less diversified than before. Puerto Rico is not a global player. It's a player within the U.S. domestic economy, and I don't think that's good for Puerto Rico. You don't see Florida or California or Illinois doing that. They're all internationalizing."

Nevertheless, Puerto Rico does enjoy a per-capita income of $9,045, far higher than most of its Caribbean and Latin American neighbors. Drug workers earn close to $12 an hour, while the overall manufacturing wage is just under $9 an hour. In addition, unemployment is around 10% -- down from 17.9% in 1992, when Rossello took office, and the lowest in 30 years.

"We're actually very confident it will go under 10% before the year is over," said Romeu, who served as executive director of the Puerto Rico Federal Affairs Administration in Washington before assuming his current job in January. "This is the first time in the history of Puerto Rico that an outoging governor will end his term with fewer government employees than he started. That's logical, given all his privatization efforts."

Another Rossello initiative involves the construction of a $1 billion transshipment hub linking the U.S. mainland and Latin America, Europe and Asia.

Rossello announced in late July that Guayanilla, a municipality of 27,000 people perched on the island's south coast, had been selected as the site for the transshipment port, based on a feasibility study commissioned by the Government Development Bank (GDB).

If it ever comes to pass, Guayanilla would vie with Kingston, Jamaica; Freeport, Bahamas, and even San Juan for transshipment business.

"The transshipment port will turn the island's southern region into a new focus for development, bringing a multiplier effect that will benefit the island," said GDB President Lourdes Rovira, explaining that the government will finance $360 million, or 35%, of the project's total cost. The remaining 65% would be financed by private investors to cover the cost of engineering services and infrastructure, though the Puerto Rican government would own the port facility's land and equipment.

Proponents hope that at least half of all merchandise transported out of Guayanilla will acquire added value at local manufacturing facilities before it is shipped abroad, further encouraging the establishment of free-zone garment, electronics, medical-devices and other kinds of factories.

Hector Rivera, executive director of the Puerto Rico Ports Authority, says San Juan -- long the island's leading port -- last year handled 1,990,275 TEUs. Less than 5% of that was transshipment cargo, a figure he says can be substantially improved given the right conditions.

"Strategically, Puerto Rico is a natural place to handle transshipment of cargo that comes east-west or north-south," said Rivera. "But we have learned that for the port to be successful, you have to have a local economy. In Freeport, everything that goes in goes out. There is no local economy. They have been successful, but not in the way they first thought they'd be."

The GDB claims its so-called "megaport" will create 50,000 jobs in Guayanilla, which suffers from a 16.3% unemployment rate. It also said that upon completion, the transshipment facility -- to be built in three phases over a 10-year period -- would contribute $6 billion to Puerto Rico's gross domestic product.

At the moment, the Ports Authority is conducting an "industry outreach program" to drum up interest among prospective investors. One possible contender is the Dutch Consortium, an investment group led by the Port of Rotterdam and including Dutch shipping companies, engineering firms, construction companies and two banks.

Yet Leo Holt, spokesman for Philadelphia-based Holt Group Inc., which owns the Navieras shipping, questions the Guayanilla project's return on investment.

"We have been developing marine terminals for the last 30 years. They are complex organisms, and they have a multitude of regulatory requirements to make them happen," he said. "This project is a generation away at best."

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