Elec. Arts, Inc. v. Comm'r of Internal Revenue

Decision Date22 March 2002
Docket NumberNos. 2433–99,2434–99.,s. 2433–99
Citation118 T.C. 226,118 T.C. No. 13
PartiesELECTRONIC ARTS, INC. and Subsidiaries, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentELECTRONIC ARTS PUERTO RICO, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Corporate taxpayers petitioned for redetermination of deficiency and moved for partial summary judgment on issues relating to application of its possessions tax credits. The Tax Court, Chabot, J., held that: (1) taxpayers met the active conduct of a trade or business in Puerto Rico requirement; (2) taxpayers maintained a significant business presence in Puerto Rico based on supervision of workers; but (3) taxpayers were not entitled to partial summary judgment that they maintained a significant business presence in Puerto Rico to characterize products as manufactured in Puerto Rico.

Motion granted in part. A. Duane Webber and Andrew P. Crousore, for petitioners.

Michael R. Cooper, William R. Davis, Jr., Gregory M. Hahn, and Virginia L. Hamilton, for respondent.

OPINION

CHABOT, J.

Before the years in issue, petitioner parent (EA) had relied on unrelated video games manufacturers in Taiwan and Japan to manufacture the video games that EA sold. EA created a subsidiary (EAPR) to move the video game manufacturing operations to Puerto Rico. EAPR entered into agreements with an unrelated company (PPI), which was located in Puerto Rico. PPI manufactured ignition modules and related products for small engines. PPI did not own equipment, raw materials, or components to manufacture video games. Under the EAPR–PPI agreements, EAPR leased space in PPI's factory, leased employees from PPI, bought capital equipment which was installed in the leased space, bought components and raw materials, and provided the foregoing to PPI in order to manufacture video games. PPI was paid for its services. EAPR sold the resulting video games to EA. The video games in dispute that EA bought from EAPR were manufactured in Puerto Rico.

Petitioners moved for partial summary judgment, contending that (1) EAPR is entitled to possessions tax credits because it met the “active conduct of a trade or business” in Puerto Rico requirement of sec. 936(a)(2)(B), I.R.C.1986, and (2) in determining the amount of these credits, EAPR is entitled to compute its income under the profit split method (sec.936(h)(5)(C)(ii), I.R.C.1986) because it maintained a “significant business presence” in Puerto Rico within the meaning of sec. 936(h)(5)(B)(ii), I.R.C.1986.

1. Held: Ps are entitled to partial summary judgment that EAPR met the “active conduct of a trade or business” in Puerto Rico requirement of sec. 936(a)(2)(B), I.R.C.1986. MedChem (P.R.), Inc. v. Commissioner, 116 T.C. 308, 2001 WL 530695 (2001), on appeal (1st Cir., Aug. 24, 2001), followed as to the law and distinguished on the facts.

2. Held, further, Ps are entitled to partial summary judgment that EAPR maintained a “significant business presence” in Puerto Rico within the meaning of sec. 936(h)(5)(B)(ii), I.R.C.1986, without regard to the requirements of the final flush language of that provision.

3. Held, further, Ps have failed to show that they are entitled to partial summary judgment that EAPR maintained a “significant business presence” in Puerto Rico within the meaning of sec. 936(h)(5)(B)(ii), I.R.C.1986, taking into account the requirements of the final flush language of that provision. That is, Ps have failed to show that the video games were “manufactured * * * in * * * [Puerto Rico] by * * * [EAPR] within the meaning of subsection (d)(1)(A) of section 954, I.R.C.1986.

The instant cases are before us on petitioners' motion under Rule 121 1 for partial summary judgment that petitioner Electronic Arts Puerto Rico, Inc. (hereinafter sometimes referred to as EAPR), is entitled to possessions tax credits under section 936 2 for the years in issue computed using the “profit split method”.

Respondent determined deficiencies in corporate income tax against petitioner Electronic Arts, Inc. and Subsidiaries (hereinafter sometimes referred to as EA) and against petitioner EAPR, as follows:

+------------------------------------+
                ¦Fiscal Year 1  ¦EA       ¦EAPR      ¦
                +---------------+---------+----------¦
                ¦               ¦         ¦          ¦
                +---------------+---------+----------¦
                ¦1993           ¦$121,795 ¦$1,977,045¦
                +---------------+---------+----------¦
                ¦1994           ¦1,239,846¦2,959,550 ¦
                +---------------+---------+----------¦
                ¦1995           ¦7,000,775¦2,646,755 ¦
                +---------------+---------+----------¦
                ¦               ¦         ¦          ¦
                +------------------------------------+
                

Petitioners claim overpayments as follows:

+-----------------------------+
                ¦Fiscal Year ¦EA 1     ¦EAPR  ¦
                +------------+---------+------¦
                ¦            ¦         ¦      ¦
                +------------+---------+------¦
                ¦1993        ¦$65,000  ¦$4,519¦
                +------------+---------+------¦
                ¦1994        ¦65,000   ¦7,739 ¦
                +------------+---------+------¦
                ¦1995        ¦1,450,000¦—     ¦
                +------------+---------+------¦
                ¦            ¦         ¦      ¦
                +-----------------------------+
                

The issues for decision under petitioners' motion for partial summary judgment are as follows:

(1) Whether EAPR was engaged in the active conduct of a trade or business in Puerto Rico during the years in issue and was entitled to section 936 possessions tax credits for these years. (This issue affects both dockets.)

(2) If yes, then whether EAPR had a significant business presence in Puerto Rico, with respect to the manufacture 3 of standardized video game cartridges (hereinafter sometimes referred to as video games), during the years in issue so as to entitle EAPR to elect to use the profit split method in lieu of the general rule of section 936(h)(1). Subsidiary questions are (a) whether the video games were manufactured in Puerto Rico, and (b) whether EAPR's activities constituted the manufacture of the video games in Puerto Rico by EAPR “within the meaning of subsection (d)(1)(A) of section 954, as required by section 936(h)(5)(B)(ii) (final flush). (This issue affects only the EAPR docket, 2434–99.)

Our statements as to the facts are based entirely on the parties' stipulations of facts and exhibits, those matters that are admitted in the pleadings, those matters that are admitted in the motion papers, and those matters set forth in affidavits submitted by the parties.

I. Background
A. The Petitioners

When the respective petitions were filed in the instant cases, both EA and EAPR were Delaware corporations with their principal corporate offices in Redwood City, California. (EA was incorporated in Delaware in September 1991; its predecessor was incorporated in California in 1982.) For the years in issue, both EA and EAPR kept their books and filed their income tax returns on the basis of an accrual method of accounting and a fiscal year ending March 31.

During the years in issue, EA developed, manufactured (or had manufactured), marketed, and distributed interactive entertainment software for a variety of entertainment systems, including such well-known entertainment systems as the Sega Genesis, Sony Playstations, and Nintendo Systems, as well as Apple and IBM-compatible computers. EA derived its revenues during the years in issue predominantly from the sale to both U.S. and foreign customers of standardized video game cartridges and compact discs containing entertainment software. Under a license agreement between EA and Sega Enterprises Ltd. (hereinafter sometimes referred to as Sega), dated July 1992, Sega granted to EA and any affiliate controlled by EA a license to use Sega intangible property to develop, manufacture, market, and sell video game cartridges compatible with the Sega Genesis systems. EA distributed products primarily through its own sales force in the United States, which sold directly to retail chains and outlets. Outside the United States, EA distributed its products primarily through affiliates and third-party distributors.

Before the years in issue, EA relied on unrelated video game manufacturers located in Taiwan and Japan to manufacture the video games.

Beginning in 1991 (during EA's fiscal 1992), EA became interested in, and investigated the feasibility of, establishing a video game undertaking in Puerto Rico through a wholly owned subsidiary. In 1992, EA engaged Richard Baker as a consultant to provide advice in connection with the investigation and establishment of such an undertaking. EAPR was incorporated under Delaware law on May 15, 1992, as a subsidiary of EA, to manufacture video games and other software entertainment products. EA bought video games from EAPR in each of the years in issue.

B. Agreements; Procedures

EA issued purchase orders to EAPR for video games. EA generated these purchase orders in San Mateo, California. When EAPR, through its manager and employees covered by the Manufacturing Services Agreement (hereinafter sometimes referred to as the Agreement), shipped completed video games to EA, EAPR's manager or an employee covered by the Agreement (hereinafter sometimes referred to as a lease employee) input into EAPR's computerized Material Requirement Planning System (hereinafter sometimes referred to as the MRP System) shipping data relating to the shipment. (The Agreement, including the arrangements as to lease employees, is described in greater detail infra I.E.) The MRP System was used to manage EAPR's inventories by tracing (a) raw materials and components as inputs and inventory, (b) production schedules, (c) movements of material and component inventories through stages of the manufacturing process, and (d) finished video games as outputs relating to the manufacture of video games in Puerto Rico. An invoice from EAPR then was generated in San Mateo with respect to the completed video games. EA, through its accounting department, paid EAPR's invoices by making wire transfers from EA's bank account to EAPR's bank...

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