Medchem (P.R.), Inc. v. C.I.R.

Decision Date10 July 2002
Docket NumberNo. 01-2251.,01-2251.
Citation295 F.3d 118
PartiesMEDCHEM (P.R.), INC., Petitioner, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.
CourtU.S. Court of Appeals — First Circuit

David A. Hickerson with whom Lisa R. Fine and Weil, Gotshal & Manges, LLP were on brief for appellant.

A. Duane Webber and Baker & McKenzie on brief for Electronic Arts Puerto Rico, Inc., amicus curiae.

David English Carmack, Attorney, Tax Division, Department of Justice, with whom Eileen J. O'Connor, Assistant Attorney General, and Kenneth W. Rosenberg, Attorney, Tax Division, Department of Justice, were on brief for appellee.

Before SELYA, Circuit Judge, STAHL, Senior Circuit Judge, and LYNCH, Circuit Judge.

LYNCH, Circuit Judge.

This tax case requires interpretation of the Internal Revenue Code's Puerto Rico and Possession Tax Credit provision, 26 U.S.C. § 936 (2000), which permits a domestic corporation to elect a possession tax credit if it meets certain conditions, id. § 936(a). The condition on which this case turns is that 75% or more of the gross income of the corporation for the three preceding years must be "derived from the active conduct of a trade or business within a possession of the United States." Id. § 936(a)(2)(B).1

The taxpayer, MedChem (P.R.), Inc. ("M-PR"), contends that it meets this "active conduct of a trade or business" requirement; the Tax Court and the Commissioner of Internal Revenue disagree. This issue appears to be one of first impression at the circuit level.

The particular tax credit codified at § 936 was added by the Tax Reform Act of 1976, Pub.L. No. 94-455, 90 Stat. 1520 (1976) (codified in scattered sections of 26 U.S.C.), although it has its roots in legislation from the 1920s, see Revenue Act of 1921, Pub.L. No. 67-98, § 262, 42 Stat. 227, 271 (1921). The government tells us that the tax credit is in the process of being phased out. See 26 U.S.C. § 936(j). This case has, in the interim, consequences for domestic corporations involved in business activity in Puerto Rico2 and certain other possessions. Unfortunately, there are no promulgated regulations under § 936(a) and domestic corporations have been forced to make business arrangements in U.S. possessions without the prior guidance such regulations might provide.

Based primarily on § 936's text, understood in the context of the legislative history, we conclude that M-PR has failed to meet the "active conduct of a trade or business" requirement and, accordingly, we affirm the Tax Court's judgment. We do so without adopting the Tax Court's proposed test for what constitutes the active conduct of a trade or business in a U.S. possession for purposes of § 936(a).

I.

The facts in this case are not in dispute, Medchem (P.R.), Inc. v. Comm'r, 116 T.C. 308, 310, 2001 WL 530695 (2001); see generally Tax Ct. R. 122, although M-PR contests the inferences the Tax Court drew from the stipulated record. M-PR is the taxpayer claiming to qualify for the possessions tax credit.

M-PR's identity has gone through several transformations. M-PR was incorporated in Delaware on December 8, 1987, as MedChem Puerto Rico, Inc. A couple of weeks later, on December 22, MedChem Puerto Rico, Inc. changed its name to BioChem Products, Inc. Then, on March 1, 1992, BioChem Products, Inc. changed its state of incorporation to Massachusetts and, on November 25, 1992, changed its name to MedChem P.R., Inc. M-PR and all of its predecessors — all of which we will refer to as M-PR — were at all times wholly owned subsidiaries of MedChem Products, Inc. ("M-USA"). M-USA is a Massachusetts corporation with its principal place of business in Woburn, Massachusetts. Following the tax years at issue in this case,3 M-USA succeeded M-PR through a merger of M-PR into M-USA.

The IRS found a deficiency of $815,1964 in M-PR's federal income tax paid for the tax year ending August 31, 1992, and a deficiency of $1,705,019 in M-USA's tax payments for the same period. In consolidated cases in the Tax Court, M-USA, as successor by merger to M-PR, contested both of these claims of deficiency. Medchem, 116 T.C. at 309. It is the $815,196 liability that is at issue here.

During the relevant three-year period — that is, during each of M-PR's taxable years ending on August 31, 1990-92 — all of M-PR's reported income was "intangible property income," see 26 U.S.C. § 936(h)(3), attributable to the sale of Avitene, a blood-clotting drug manufactured by Alcon Puerto Rico, Inc. ("A-PR"), an unrelated company.

On December 18, 1987, ten days after M-PR was incorporated, A-PR along with Alcon Pharmaceuticals, Ltd. and Alcon Laboratories, Inc. (collectively "Alcon entities") sold the Avitene portion of their business to M-PR and M-USA. The Alcon entities sold the equipment, raw materials, technology, and other assets associated with Avitene's manufacturing. M-USA acquired the receivables, non-competition agreements, goodwill, contract rights, records, patents and related know-how, trademarks, and Food and Drug Administration approvals. M-PR acquired receivables, inventory, and title to the machinery and equipment located within A-PR's manufacturing facility in Humacao, Puerto Rico. Those assets did not include A-PR's Avitene manufacturing facility in Humacao.

Before the acquisition, A-PR had been the manufacturer of Avitene. M-USA had nothing to do with the drug. Until ten days prior to the acquisition, M-PR did not exist. As part of the sale, A-PR agreed to continue manufacturing Avitene for M-PR using A-PR's own facility and labor and M-PR's recently-acquired raw materials and equipment. A-PR also used the technology acquired by M-USA. M-PR held title to the in-process and finished Avitene. A-PR shipped finished Avitene from its facility to M-USA, and title passed to M-USA, the purchaser. A-PR was solely responsible for any issues that arose until the finished product was delivered to a carrier for shipment to M-USA. In return, A-PR sent its invoices for its manufacturing services directly to M-USA, which paid, from M-PR's account, a price equal to the manufacturing cost plus 10%. The primary change effected by the 1987 sale was that certain assets were held in the name of either M-PR or its parent, M-USA.

The reason M-PR entered into the processing agreement with A-PR, in which A-PR manufactured Avitene for M-PR using M-PR's raw materials and equipment, was that M-PR needed to ensure a steady supply of Avitene until it built its own manufacturing facility in Puerto Rico. As it turns out, M-PR later abandoned its plan to construct its own Avitene facility in Puerto Rico.

During much of the relevant three-year period, M-PR had no employees. Its one employee, Mr. Perez, was a former A-PR employee. He worked for M-PR from March 1988 to June 1990 out of a one-room office that M-PR maintained. Mr. Perez spent much of his time planning M-PR's transition to its own Avitene manufacturing facility. M-PR also paid three independent contractors to assist Mr. Perez. M-PR treated the independent contractors as nonemployees for payroll and tax purposes. M-USA and A-PR employed the individuals, other than Mr. Perez and the independent contractors, associated with the Avitene manufacturing and sales business.

At the time of the 1987 processing agreement, M-PR and M-USA had hoped to establish their own manufacturing facility in Puerto Rico. M-PR purchased land in Puerto Rico, on which it planned to build its own Avitene manufacturing facility. In early 1990 M-USA suffered financial reverses causing it to lay off a third of its workforce and to default on $10 million in debt. As a result, M-PR suspended its plans to construct a manufacturing facility in Puerto Rico. M-PR then wrote off its capital expenditures that had been made on the new facility and closed its Puerto Rico office. When the office closed, Perez transferred M-PR's business records to A-PR and M-USA. As of July 1, 1990, all M-PR checks were issued by M-USA from M-USA's Woburn, Massachusetts office.

In early 1990 M-USA decided to move the manufacturing equipment and processes from A-PR's Humacao facility to M-USA's facility in Woburn. Significant elements of the equipment were moved from Humacao to Woburn by June 1990 and, by January 1991, all of the manufacturing equipment necessary to perform the first phase of the manufacturing process had been moved to Woburn. In October 1992, first-phase Avitene production commenced in Woburn. By April 1994, M-USA had substantially completed the construction, in Woburn, of its Avitene finished goods manufacturing facility.

II.

For its tax year ending August 31, 1992, M-PR claimed a tax credit under § 936. The Commissioner determined that M-PR's Avitene income was not "derived from the active conduct of a trade or business" within a possession as § 936(a)(2)(B) requires. Accordingly, the Commissioner issued a notice of deficiency in the amount of $815,196.

M-USA, as successor by merger to M-PR, contested the asserted deficiency. On June 27, 2001, the Tax Court entered its final decision, finding that M-PR was deficient, in the sum of $815,196, in its federal income tax payments. The Tax Court concluded that M-PR did not meet § 936(a)(2)(B)'s "active conduct of a trade or business within a possession" requirement. Medchem, 116 T.C. at 309, 328-29. The Tax Court held that

for purposes of section 936(a), a taxpayer actively conducts a trade or business in a U.S. possession only if it participates regularly, continually, extensively, and actively in the management and operation of its profit-motivated activity in that possession.... [F]or the purpose of this participation requirement, the services underlying a manufacturing contract may be imputed to a taxpayer only to the extent that the performance of those services is adequately supervised by the taxpayers's own employees.

Id. at 336-37.

The Tax Court concluded that M-PR did not meet this test. Id. at...

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