Tax & AccountingSeptember 22, 2020

Puerto Rico Company’s Tax Reduction and Avoidance Strategies Were Not Trade Secrets


Puerto Rico Company’s Tax Reduction and Avoidance Strategies Were Not Trade Secrets

A Puerto Rican company’s tax reduction and avoidance strategies were not entitled to protection as trade secrets. In fact, the First Circuit’s opinion in TLS Mgmt. and Mktg. Services. LLC v. Rodriguez-Toledo suggests that it may not be possible for any such tax strategy to qualify as a trade secret.

TLS Claimed Former Employee Stole Trade Secrets

TLS was a tax management and consulting firm based in Puerto Rico. It marketed two strategies that it claimed were trade secrets:

  • the U.S. Possession Strategy, and
  • the Capital Preservation Report (CPR).

TLS claimed that a former employee stole these trade secrets when he improperly downloaded CPR agreements between TLS and two of its clients. He and his controlled companies then used the agreements and the U.S. Possession strategy to help those clients escape their agreements with TLS.

The district court agreed that TLS’s U.S. Possession Strategy and CPRs were trade secrets that were misappropriated by the former employee. However, the First Circuit Court of Appeals reversed the decision and directed a judgement in favor of the defendants

TLS Strategies Arbitraged Differences Between U.S. and Puerto Rican Taxes

TLS’s U.S. Possession strategy basically arbitraged U.S. income tax rates against TLS’s much lower rate in Puerto Rico. Under the strategy, a business owner in the U.S. became a member of TLS, and then outsourced some business activities to TLS. For U.S. tax purposes, the client could deduct the fees it paid to TLS. In Puerto Rico, TLS paid only a 4% tax on the outsource income.

Bu Wait, There’s More!

TLS could also make tax-free distributions to Puerto Rico residents. Thus, if clients moved to Puerto Rico, TLS could distribute earnings to them tax-free, effectively returning the fees the clients paid for the services they outsourced to TLS. Clients who did not move to Puerto Rico could receive similar benefits by taking out tax-free “loans” from TLS.

Accordingly, the U.S. Possessions Strategy effectively:

  1. allowed clients to deduct fees they paid for services they outsourced to TLS;
  2. applied a 4% tax rate on TLS income from those services; and
  3. allowed TLS to distribute its related income to the client tax-free.

However, clients would suffer adverse tax consequences if they prematurely terminated their agreements with TLS.

CPR Offered Recommendations Tailored to the Client

The CPRs were more straightforward. A CPR provided tax recommendations that were specific to the TLS client, based on TLS’s analysis of applicable statutes and regulations.

U.S. Possessions Strategy and CPRs Were Not Trade Secrets

The First Circuit concluded that the U.S. Possessions Strategy and the CPRs were not trade secrets. A trade secret must offer potential independent financial value or provide a business advantage through information that is not common knowledge and is not readily accessible through proper means. However, the U.S. Possessions Strategy and the CPRs were largely based on publicly available information.

U.S. Possessions Strategy Was Based on Well-Known Steps

Specifically, TLS marketing materials assured clients that the steps in the U.S. Possessions Strategy were all well-known. Nevertheless, TLS claimed at trial that its mechanism for allowing non-Puerto Rico residents to receive tax-free TLS income—that is, the “loans” TLS made to the clients—were unique.

However, one of the principals also admitted that the loans were based on well-developed models used in the U.S. Virgin Islands. Moreover, even if the loan strategy was not well-known, TLS failed to show that it was not readily ascertainable from public sources.

CPRs Contained Only Publicly Available Information and Individual Client Information

Similarly, TLS failed to show that a CPR contained anything other than publicly available information, such as descriptions and analyses of statutes and regulations; and information about the particular client. Unfortunately for TLS, neither type of information constituted a trade secret.

Can a Tax Strategy Ever be a Trade Secret?

The law generally prohibits patents for tax strategies. The First Circuit’s analysis raises almost as high a bar for protecting a tax strategy as a trade secret.

Almost by definition, most tax reduction strategies that even purport to be legal must rely on existing statutes, regulations, court decisions, and other authorities—all publicly available information. And incorporating information about the user doesn’t help, because information about clients and customers is not a trade secret.

First Circuit’s Decision May Reach Beyond Puerto Rico

Of course, the First Circuit applied a Puerto Rican statute that defined a “trade secret.” However, the Puerto Rican law was based on the Uniform Trade Secrets Act, which also excludes publicly available information and customer information from the definition of “trade secret.”

Since the Uniform Act has been adopted by almost all U.S. states, the District of Columbia, and the U.S. Virgin Islands, the First Circuit’s approach makes it unlikely that similar tax reduction strategies in other jurisdictions can be protected as trade secrets.

By Kelley Wolf, J.D., LL.M.

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