Puerto Rico, as a U.S. territory, has had favorable tax treatment for its investors for decades. The island is a separate fiscal jurisdiction from the mainland U.S., a status that offers its residents unique tax protections.
Income that a resident of Puerto Rico earns from a bond issued by the commonwealth is 100 percent free from U.S. taxation; however, if a resident owns a security issued outside of Puerto Rico, the income is subject to U.S. taxes, just like any other American citizen.
This is what "led ultimately to the creation of a capital market in Puerto Rico," Carlos Ubinas, the current president of UBS Puerto Rico's broker-dealer and trust company, explained to a FINRA panel in 2015 during sworn testimony.
UBS Puerto Rico, a subsidiary of UBS Financial Services headquartered in Weehawken, New Jersey, is the largest broker-dealer on the island, controlling about 49 percent of total retail brokerage assets at its peak.
The broker-dealer has been the primary underwriter of a series of closed-end fund companies since the mid-1990s. And managed or co-managed 23 proprietary closed-end funds that could only be sold to Puerto Rico residents and corporations whose primary place of business is on the island.
Two types of funds, open-end and closed-end mutual funds, are managed by UBS Asset Managers of Puerto Rico. Each fund offers "its own investment strategy, management style and level of risk," the fund disclosure document says.
The open-end funds allow investors to continually buy and redeem shares by adding or withdrawing their money from the fund with no limit to the number of shares that can be issued.
The closed-end funds issue a fixed number of shares to raise capital, similar to how an initial public offering stateside operates. After the IPO, the shares of the funds are traded in the secondary market between investors.
"They were an extremely popular investment on the Island until the 2013 market collapse because they consistently provided high rates of return with very substantial tax advantages that were only available to Puerto Rico residents who invested in Puerto Rico securities," UBS said in a statement, in response to CNBC inquiries about the funds.
The funds provided Puerto Rico-based investors the ability to own a portion, up to 33 percent of the fund's total assets, of U.S. mainland-issued securities, while still retaining the characteristics of a Puerto Rico investment. At least 67 percent of the fund's total assets had to be invested in Puerto Rico obligations in order for the income to be tax-free.
"The [closed-end funds] provided diversification as up to one third of the holdings were in obligations issued or guaranteed by the U.S. government," a UBS spokesman said.
They were marketed to investors with the objective of current income, consistent with the preservation of capital.