Understanding the Rum Cover-Over

Imagine a world where the government returns half of your business taxes each year. As a bonus, the government also pays to market your product and upgrade your factory equipment. Sounds like a sweet deal, right? As it turns out, this is the deal that several of the largest rum makers in the world have.

Welcome to the bizarre world of the “rum cover-over.” The name is dull as drying paint, and the subject involves arcane tax policies that make one’s eyes glaze over. But dig in, and you’ll learn of multi-billion-dollar companies receiving hundreds of millions of dollars in subsidies each year from the economically strapped island governments of Puerto Rico and the U.S. Virgin Islands.

It wasn’t always this way. For its first 90 years, the cover-over program drew little public attention. But things took a wild and unexpected turn in 2009. What follows is a dramatically simplified tale that begins in the age of American imperial expansion.

Puerto Rico Becomes an American Territory

When the Spanish-American War ended in 1898, Spain ceded its claims on Puerto Rico to the U.S., making the island an American territory. Two decades later, the U.S. Congress enacted the Jones-Shafroth Act, establishing Puerto Rico’s island government. Governments and public infrastructure projects are expensive, so to help Puerto Rico make much-needed improvements, Congress directed that federal taxes paid by Puerto Rican manufacturers should go to Puerto Rico’s treasury rather than the U.S. treasury.

Technically, Puerto Rico’s spirits manufacturers pay their taxes to the U.S. treasury. Per the act’s wording, those excise funds are later “covered into the treasury of Porto Rico.” It’s this phrase that gives us the unwieldy “cover-over” name.

Puerto Rico’s rum makers have long been among the island’s most profitable industries. Since they pay the standard hefty federal excise taxes for every gallon of rum distilled, the island’s producers have effectively paid for much of its infrastructure for over a century.

Puerto Rico’s treasury got a healthy boost when Bacardi opened a distillery there in 1936 to complement its existing Cuban and Mexican operations — and to circumvent high U.S. import tariffs on foreign spirits.

Rums of Puerto Rico – A Small Slice of the Pie

For 30 years, Puerto Rico’s cover-over program operated as originally intended, with all the island distillers’ federal taxes flowing to the local government via federal coffers. Then, in 1948, the government created the Rums of Puerto Rico program, which was funded from cover-over revenue. The program promoted Puerto Rican rum sales via advertising, trade shows, and cocktail competitions. By making a small investment in promoting the island’s rum sales, the government hoped to recoup that investment several times over from increased cover-over funds in the future.

Over 75 years later, the Rums of Puerto Rico program is still in effect. Between 2006 and 2010, $25 million was allocated to the program annually, which was around six percent of the cover-over funds received. Although a relatively small percentage of the total cover-over funds Puerto Rico received, $25 million is a significant amount of money the island’s rum makers didn’t have to spend on advertising themselves.

The U.S. Virgin Islands Adopts the Cover-Over Program

In 1954, the U.S. government reconfigured the U.S. Virgin Islands’ (USVI’s) territorial government with a similar cover-over scheme as Puerto Rico’s, thus enabling federal alcohol taxes paid by USVI rum makers to flow to the USVI treasury. Cruzan, aka Cruzan VIRIL, was the territory’s largest producer at the time.

In 1967, the USVI government started subsidizing Cruzan VIRIL’s molasses costs, noting later:

“The effect of the molasses payments is to maintain the competitive position of Virgin Islands rum producers, after the demise of the Virgin Islands sugar cane industry, relative to the rum producers in other countries where local molasses supplies are readily available.”

Although not explicitly stated, the molasses subsidy is almost certainly funded by the USVI’s cover-over funds. Between 1995 and 2004, Cruzan VIRIL’s molasses subsidy averaged $2.5 million annually. In the 1970s, a USVI program used cover-over funds for magazine advertisements promoting Virgin Islands rum, similar to what the Rums of Puerto Rico program started decades earlier.

In short, starting in the mid-20th century, both territories directly or indirectly subsidized their rum producers with funds from cover-over revenues originally intended for public infrastructure investments.

Stacking the Deck for Puerto Rico and the USVI: Caribbean Basin Initiative

In the early 1980s, the Caribbean Basin Initiative (CBI) sought to economically assist Caribbean and Central American nations via tariff reductions and trade preferences. Foreign rum entering the U.S. was one of the beneficiaries of tariff reductions.

Fearing that these reduced tariffs might depress Puerto Rican and USVI rum sales, thus decreasing cover-over money flowing to those territories, the CBI legislation included a provision to counteract this potential problem. Per the CBI, taxes paid by foreign rum makers were added to the cover-over funds sent to Puerto Rico and the USVI. It was a minor detail then, but it became controversial decades later.

Negotiating a Slice of the Cover-Over Pie

By the start of the 21st century, cover-over funds going to the USVI and Puerto Rico had ballooned to $7.6 billion over an 18-year period. Puerto Rico took 85 percent of the cover-over funds during this time, primarily due to the huge production of Bacardi and Destilería Serrallés, the home of Don Q rum. (See table below).

The cover-over program remained a sleepy backwater of American tax policy until 2008, when the USVI and Puerto Rico began competing with each other for the same slice of the pie, setting in motion a chain of events that radically restructured who received cover-over money.

Between the 1980s and 2010, Destilería Serrallés licensed the Captain Morgan brand name to sell its rum in the U.S. and Caribbean alongside its own Don Q brand. The federal taxes paid for Captain Morgan–branded rum contributed a substantial share of Puerto Rico’s cover-over funds during the period.

Hoping to lure this cover-over money to the USVI, the USVI government made a deal with Diageo, which owns the Captain Morgan brand. In what Diageo calls a public-private initiative, the company agreed to start distilling Captain Morgan rum in St. Croix and discontinue its license with Serrallés. Cover-over funds that would have gone to Puerto Rico instead went to the USVI.

In exchange, the USVI government provided Diageo with incentives, including:

• A new distillery costing $165 million
• Molasses subsidies
• Paying 35% of Diageo’s advertising costs for Captain Morgan rum
• A 90% income tax reduction and exemption from property taxes
• Up to 47.5% of all tax revenue collected on Captain Morgan rum

The last item is the crux of the cover-over controversy. Nearly half the cover-over funds that in the past would have gone to the USVI treasury now go to Diageo. The cost to the USVI government has been estimated to be $2.7 billion over the deal’s 30-year term.

Seeing the deal’s generous terms, Cruzan VIRIL wanted a similar deal as its new island neighbor — and got one. In exchange for a 30-year commitment to continue making rum on St. Croix, the USVI paid $30 million for a new wastewater treatment facility, $75 million to expand Cruzan’s distillation capacity from 10.5 million to 15.5 million proof gallons annually, plus:

• Reduction or elimination of certain taxes, including corporate income tax
• Molasses, marketing, and rum promotion support payments
• Production support payments

The USVI paid handsomely to retain and attract large-scale rum production in St. Croix, thus ensuring a steady stream of cover-over revenue. The sweet deals for rum makers didn’t end there, however.

Puerto Rico Responds

Once the two USVI producers started receiving a slice of the cover-over revenues, Puerto Rico acted quickly to ensure its rum makers stayed put by making similar agreements with Bacardi and Destilería Serrallés. In 2011, Puerto Rico signed a deal for a new distillery named Club Caribe to distill in Puerto Rico and receive a share of the cover-over funds.

By 2012, five USVI and Puerto Rican rum producers, each distilling at least several million proof gallons annually, were receiving significant percentages of cover-over funds originally intended for island infrastructure. Simply put, these agreements are subsidies. As with the earlier USVI deals, each producer’s production support payment depends on what it paid in taxes rather than a percentage of the total cover-over funds received by the island.

Cover-Over Hangover

The sea change in cover-over fund distribution caused a rash of infighting and legal challenges between the producers and island governments. Foreign rum producers also entered the fray. Per the Caribbean Basin Initiative, spirits taxes from foreign rum makers go to the cover-over pool, and those producers objected to their taxes subsidizing their American competition. As a point of reference, import taxes from foreign rum contributed $67 million to the 2010 cover-over pool divided between the USVI and Puerto Rico.

The West Indies Rum & Spirits Producers’ Association (WIRSPA), the trade group representing CARICOM rum producers, publicly spoke out against the new cover-over subsidies, saying they were unfair and grossly distorted the U.S. rum market. There was talk of raising the issue with the World Trade Organization, but it ultimately didn’t come to pass.

A decade later, in 2023, the Beer Institute (StandWithBeer.org) also took aim at the cover-over, creating a web page and a video asserting that the cover-over benefits liquor companies instead of the people of Puerto Rico and the U.S. Virgin Islands. Of course, the cynic will point out that the subsidies also benefit the beer industry’s competition.

The Rum Cover Today

The above narrative barely scratches the surface of the rum cover-over story; a detailed recounting of all the twists, turns, and battles could easily fill a book.

The cover-over agreements for Diageo, Cruzan VIRIL, and Bacardi are available online, although they are fiendishly complex and filled with astronomical numbers of provisional clauses and tables. Among the common elements are yearly minimum production levels and payout percentages that depend on whether the rum sold is branded or bulk rum.

For fiscal year 2021, Puerto Rico received $519 million in cover-over payments and the USVI received $281 million — collectively $800 million in total. A conservative estimate of 30% of that amount going to rum makers is $250 million annually. No other rum maker selling rum in the U.S. market receives anything close to this. Subsidies at this scale allow the recipient’s rum to be sold at lower prices while retaining similar profits. It’s one factor contributing to why Puerto Rican and USVI rums are often sold at significantly lower prices than their competition.

As of 2024, USVI and Puerto Rico producers are roughly halfway through the various multi-decade agreements with their island governments. Short of something extremely unforeseen, cover-over funds will continue flowing to those producers for quite some time.

This article is adapted from the “Free Trade: Tariffs and Subsidies” chapter of Modern Caribbean Rum, published by Wonk Press