What Is Puerto Rico–Source Income? The Most Misunderstood Rule Under Act 60
If you are considering relocating to Puerto Rico under Act 60, there is one concept that determines everything: Puerto Rico–source income. The 4% corporate tax rate, 0% capital gains benefit, and Section 933 federal exclusion, all depend on one question: Where is the income sourced? This is where most planning gets it wrong — and where the IRS focuses during audits.
Why “Puerto Rico–Source Income” Matters
Under Internal Revenue Code §933, a bona fide resident of Puerto Rico may exclude Puerto Rico-source income from U.S. federal taxation. But U.S.-source income remains fully taxable federally. That means if income is improperly classified as Puerto Rico-source, you could face:
Federal tax exposure
Interest and penalties
Audit scrutiny
The Core Rule: Income Is Sourced Based on Activity — Not Where the Client Lives
Many people assume: “If my company is incorporated in Puerto Rico, all income is Puerto Rico-source.” That is incorrect. Sourcing is generally determined by:
Where services are performed
Where property is located
Where intangible property is used
The seller’s tax home (for certain assets)
Service Income (The Heart of Act 60 Chapter 3)
Service income is sourced where the services are performed. If you: physically perform consulting work in Puerto Rico, manage clients from Puerto Rico, develop software from Puerto Rico, then that income is generally Puerto Rico-source. If you: spend substantial time working in Florida or New York, maintain operational staff in the mainland, generate income from U.S.-based employees, that portion of income may become U.S.-source.
Client location does NOT determine sourcing. Performance location does.
Dividends
Dividends from a Puerto Rico exempt corporation to a bona fide Puerto Rico resident are generally treated as Puerto Rico-source income for Puerto Rico tax purposes. However, dividends from U.S. corporations are U.S.-source income and remain subject to federal taxation.
Interest
Interest income sourcing depends on the residence of the payer. Puerto Rico-source interest may qualify for exemption under Act 60 Chapter 2. U.S.-source interest remains federally taxable.
Capital Gains
Capital gains sourcing is more nuanced. For marketable securities, the portion of appreciation accrued after becoming a bona fide Puerto Rico resident may qualify for Puerto Rico tax exemption; pre-residency appreciation remains subject to U.S. federal tax. Not all capital gains become tax-free simply by moving. Only the portion attributable to post-residency growth may qualify.
Sale of Personal Property
Generally, gain from the sale of personal property is sourced to the seller’s tax home. If you are a bona fide Puerto Rico resident, this can create favorable sourcing treatment. However, exceptions apply — especially for inventory, dealer property, and assets connected to U.S. trade or business activity.
Retail Sales Into the U.S.?
If you operate an online retail business selling physical goods into the United States, that income is generally U.S.-source. Act 60 Chapter 3 applies primarily to eligible export services — not retail inventory sales into the mainland. Wholesale distribution may qualify in limited circumstances. Retail typically does not.
The IRS Cares, So Should You
In 2021, the IRS Large Business & International Division launched a compliance campaign targeting improper Puerto Rico tax claims. Audit focus areas include:
Improper residency claims
Misclassification of U.S.-source income
Failure to properly allocate pre-move appreciation
Failure to file Form 8898
Conclusion
Puerto Rico’s tax incentives are powerful — but they are nuanced. You must understand:
Where the income is earned
Where the services are performed
Where the economic activity occurs
How appreciation is allocated
Relocation without sourcing analysis is risky. Proper structuring can legitimately create significant tax efficiency; improper structuring can create dual exposure. If you are considering restructuring your business or relocating under Act 60, the sourcing analysis should occur before the move — not after.
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*This article is provided for informational purposes only, and does not constitute legal advice, counsel or representation.
