Electronic Arts, Inc. and Subsidiaries v. Commissioner , 118 T.C. No. 13 ( 2002 )

118 T.C. No. 13UNITED STATES TAX COURT
ELECTRONIC ARTS, INC. AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
ELECTRONIC ARTS PUERTO RICO, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 2433-99, 2434-99. Filed March 22, 2002.
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
- 2 -
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), 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.
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.
- 3 -
OPINION
CHABOT, Judge: The instant cases are before us on
petitioners’ motion under Rule 1211 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 9362 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 Year1 EA EAPR
1993 $121,795 $1,977,045
1994 1,239,846 2,959,550
1995 7,000,775 2,646,755
1
Taxable years ending March 31 of each of the years in issue.
References in this opinion to either petitioner’s fiscal years
are to that petitioner’s taxable year ending March 31 of the
indicated years. Fiscal 1996 is involved as to EA because of a
net operating loss carryback from fiscal 1996 to fiscal 1993.
Petitioners claim overpayments as follows:
1
Unless indicated otherwise, all Rule references are to the
Tax Court Rules of Practice and Procedure.
2
Unless indicated otherwise, all section references are to
sections of the Code as in effect for the years in issue, and all
Code references are to the Internal Revenue Code of 1986.
- 4 -
Fiscal Year EA1 EAPR
1993 $65,000 $4,519
1994 65,000 7,739
1995 1,450,000 --
1
EA claims these amounts as minimum overpayment amounts.
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
manufacture3 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
3
The statute uses the phrase “manufactured or produced”.
The parties’ stipulations in 12 instances refer to the video
games as having been “manufactured” and in 2 instances as having
been “produced”. It is not clear what is the congressionally
intended difference between “manufactured” and “produced”. The
Court does not discern any difference that would have
consequences for the instant cases, and, so far as we can tell
neither do the parties.
- 5 -
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,
- 6 -
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
- 7 -
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.
- 8 -
EA, through its accounting department, paid EAPR’s invoices by
making wire transfers from EA’s bank account to EAPR’s bank
account in Puerto Rico during the years in issue. After EAPR was
established, substantially all the video games that EA bought for
Sega Genesis systems were manufactured in Puerto Rico. By the
end of 1993, EA stopped buying video games for Sega Genesis
systems from unrelated parties in Asia. The video games in
dispute that EA bought were manufactured in Puerto Rico.
EAPR as lessee entered into a commercial lease (hereinafter
sometimes referred to as the Lease) with Power Parts, Inc.
(hereinafter sometimes referred to as PPI), on June 25, 1992,
relating to a portion of the facilities PPI owned in Santa
Isabel, Puerto Rico. Through 1993, the Lease applied to an area
of 4,500 square feet, which by oral agreement was increased to
6,000 square feet in 1994, and 8,000 square feet in 1995 and
later years. The leased space was segregated from PPI’s
manufacturing operations. The leased space was a room in a
different part of PPI’s building and was protected by EAPR’s
security system, which included video camera surveillance and a
combination lock door entrance. Access to the leased space was
allowed only to EAPR’s manager, EAPR’s CFO, lease employees, and
PPI employees who performed services covered by the Agreement.
The leased space was used exclusively for the manufacture of
video games and for related functions.
- 9 -
The Agreement required EAPR to provide, “at its own cost and
expense,” all the capital equipment needed to manufacture the
video games, and required this equipment to be located in the
leased space. Under the Agreement, PPI was responsible for
routine normal maintenance and EAPR was responsible for repairs,
parts, and replacement. EAPR bought, and during the years in
issue owned, all of the equipment (including wave solder
machines, production assembly lines, label machines, and test
equipment) used in Puerto Rico to manufacture the video games.
EAPR bought the equipment from unrelated sellers.
The Agreement required EAPR to provide “all materials and
components for the manufacture of Products [the video games].”
The Agreement provided that EAPR was responsible for ordering
these items and paying for them, and “PPI shall have no authority
to order or purchase or otherwise represent EAPR with respect to
such materials and components.” The manufacture of video games
required various components and materials, including ROM and RAM
chips, printed circuit boards, batteries, plastic cases, and
other parts. EAPR paid for and owned all such components and
materials used in Puerto Rico to manufacture the video games in
issue. Raw materials and components were obtained from unrelated
suppliers. EA’s personnel in San Mateo issued purchase orders to
vendors for raw materials and components on behalf of EAPR.
- 10 -
EAPR maintained its own bank account in Puerto Rico from
which it paid for raw materials and components, labor (including
amounts paid to PPI), and other supplies and services. EAPR’s
board of directors authorized officers of EAPR and two employees
of EA’s accounting department to execute checks on behalf of
EAPR. EAPR’s checks for raw materials and components, labor
(including amounts paid to PPI), and other supplies and services
were prepared and signed on EAPR’s behalf by these authorized
people in EA’s offices in San Mateo.
EA employees in San Mateo entered purchase forecast and
order information into the MRP System. Unrelated vendors shipped
raw materials and components directly to EAPR in Puerto Rico,
based on need as determined under the MRP System. Deliveries of
raw materials and components were received and inspected by
EAPR’s manager, lease employees, or PPI employees; these services
by PPI employees were covered by the Agreement. The raw
materials and components were stored in separately identified
warehouse space covered by the Lease.
At or near the end of each fiscal year, one or more lease
employees, under the supervision of EAPR’s manager and an
accounting staff person from EA who visited Puerto Rico for this
purpose, performed a physical inventory of EAPR’s materials
inventory, work in process, and finished goods.
- 11 -
At all times during the manufacture of the video games in
Puerto Rico, EAPR owned all materials and components, work in
process inventory, and finished products relating to the video
games that EA bought.
EA bought from EAPR the video games in dispute in the
instant cases. EAPR was not a sham corporation.
C. Manufacturing Process
Video games were manufactured in the leased space covered by
the Lease, that is, the leased portion of the facilities owned by
PPI in Santa Isabel. The following general steps were used in
manufacturing these video games: The raw materials and
components necessary for a production run were procured from the
warehouse space covered by the Lease and placed in the production
area as needed. The leads on various components for each video
game (including capacitors, resistors, and integrated circuits)
were formed (i.e., bent and cut, as required) using various types
of formers. The formed components were then supplied to a “push-
along” assembly line in which they were inserted, along with ROM
chips and any batteries or other required components, into bare
printed circuit boards.
The circuit boards with the inserted items4 were then placed
on the automatic conveyer in a wave solder machine, where flux
4
We assume that that is what the parties mean by their
stipulated--but undefined--term “populated boards”.
- 12 -
was deposited on the soldering points (i.e., the contact points
between the components and the printed circuit board) and the
boards were conveyed through a bath of liquid solder that
soldered the components to the board at these points. The
soldered boards were then inspected, any defective solder joints
were resoldered by hand (if possible), and any other defects were
reworked or repaired.
The boards were then cleaned and repaired to remove any
excess solder and debris, and were transferred to the testing
area where the boards were tested for electronic functionality.
The tested boards were then assembled into video game cartridge
housings, together with any other necessary components and the
appropriate labels. The finished video games were then fully
tested again for the overall functionality of the game; the
tested games were then boxed and prepared for shipping and were
subject to a further quality audit before transfer from the
leased production area covered by the Lease to the warehouse
space covered by the Lease.
The lease employees performed the above-described
manufacturing processes.
- 13 -
Table 1 shows the number of video game cartridges that were
manufactured in Puerto Rico that EAPR sold and delivered to EA
during the years in issue.5
Table 1
Fiscal Year Units
1993 2,588,306
1994 7,378,471
1995 6,485,815
1996 4,077,218
D. PPI
PPI was a Delaware corporation based in Santa Isabel; it was
an affiliate of R.E. Phelon Company, Inc., a U.S. corporation.
PPI was not related to EA or EAPR. In its Santa Isabel facility,
PPI manufactured proprietary ignition modules and related
products for use in small engines. PPI had about 300 employees
in Santa Isabel in connection with this business. PPI did not
own the equipment, raw materials, and components necessary to
manufacture video games.
E. EAPR-PPI Agreement
On June 25, 1992, EAPR and PPI entered into the Agreement,
relating to the lease employees and certain services. Under the
Agreement, EAPR was required to give to PPI (and update
5
It is not always obvious when the parties’ stipulations are
intended to refer to fiscal years and when to calendar years. In
this instance, we believe the parties intended their stipulation
to refer to fiscal years, even though the stipulation does not
say so.
- 14 -
quarterly) a forecast of the number of “employees expected to be
required by EAPR for each production or other operation and on
each shift for each calendar month”. PPI was required to “use
its best efforts to dedicate and lease to EAPR the number of
employees shown in each then current Manpower Forecast subject to
the availability of such employees.”
Under the Agreement, PPI was required to hold EAPR harmless
from any liability resulting from any third-party claim against
EAPR to the extent the liability “(iv) relates to PPI’s
employment of any employee leased to EAPR hereunder but does not
relate to EAPR’s supervision of such employee.” EAPR was
required to hold PPI harmless from any liability resulting from
any third-party claim against PPI to the extent the liability
“(vii) relates to EAPR’s supervision of any employee leased by it
from PPI hereunder”.
Under the Agreement, EAPR was required to compensate PPI for
the lease employees’ hourly wages burdened for overhead expenses,
plus a 30-percent markup. EAPR was required to pay an additional
10 percent of the employee lease charge for other services,
including receiving goods, shipping, incoming and outgoing
inspections, security, and utilities and maintenance. In return,
PPI was responsible for payroll, worker’s compensation, and
related taxes attributable to the wages of the lease employees.
Under the Agreement, EAPR made advance payments to PPI on a per-
- 15 -
video game basis with respect to the fees for the lease employees
and other services.
Under the Agreement, which sets forth a nonexclusive list of
10 “Services”, PPI agreed to provide “Day to day management of
employees leased by EAPR pursuant to Section 2 [of the
Agreement].” Section 2 of the Agreement, entitled “Lease of
Employees”, provides in pertinent part as follows:
All employees leased by PPI hereunder shall be located
in the Premises leased by EAPR from PPI and shall be
under the general supervision of EAPR. EAPR shall also
supervise and control all technical and product-related
training required by such employees. EAPR shall have
the right to locate its own employees in the building
space leased by it from PPI for the purpose of
overseeing and directing the work of the employees
leased to it by PPI subject to the requirements of the
Lease attached hereto as Exhibit A. [The Lease is not
attached to the stipulated copy of the Agreement, but
the Lease is in the record in the instant cases as a
separately stipulated exhibit.]
The Lease provides in pertinent part as follows:
3. USE: The Premises are to be used as a
manufacturing facility for the manufacture of videogame
cartridges and shall be used solely by those employees
leased from Lessor [PPI] by Lessee [EAPR] pursuant to a
manufacturing services agreement and by one additional
employee of Lessee, unless Lessor consents to use by
other employees, and for no other purpose, without the
prior written consent of Lessor.
PPI invoiced EAPR for all labor costs as specified under the
Agreement on the basis of the number of completed video games.
This invoice charge included the amount of any taxes and
unemployment contributions paid with respect to lease employees.
The amount invoiced was determined based on labor costs, taxes,
- 16 -
unemployment contributions, overhead, and a profit for PPI. EAPR
paid PPI’s invoices with respect to the lease employees and
services covered by the Agreement.
The lease employees performed manufacturing functions
relating to video games. During 1993 through 1996 the
manufacture of the video games that EAPR delivered to EA required
about 35 regular full-time employees during normal production
periods. During peak production periods up to about 400 or more
additional lease employees in multiple shifts were necessary to
meet EAPR’s production schedule.
F. EAPR’s Manager and Officers
EAPR employed a manager who at all times during the years in
issue lived in Puerto Rico and worked in the leased space.
During fiscal 1993 through fiscal 1996 (supra note 5) the
following people held the position of manager: Willie Zamora,
Jose Cruz, and Orlando Alvarado, hereinafter sometimes referred
to as Zamora, Cruz, and Alvarado, respectively. Table 2 shows
the total salaries and fringe benefits EAPR paid to its manager
during these years.
Table 2
Fiscal Year Amount
1993 $43,940
1994 61,729
1995 38,262
1996 46,035
- 17 -
Zamora died in August 1993. Cruz was hired as Zamora’s
assistant 2 weeks before Zamora died. Cruz’s employment was
terminated after 3-1/2 weeks--1-1/2 weeks after Zamora died. In
December 1993, Alvarado was hired as EAPR’s manager. During the
5 or so months after Zamora died and before Alvarado was hired, a
number of EA’s employees came to Puerto Rico on 2-week details to
do the necessary work.6 Once hired, Alvarado served as EAPR’s
manager until the summer of 1996.
As EAPR’s manager, Alvarado supervised two or three PPI
employees in charge of managing materials, from raw materials
through work in process to finished goods. Alvarado supervised
PPI employees who worked on inventory control and saw to it that
they entered the correct data into the computer for operation of
the MRP systems. In general, Alvarado did not deal directly with
the assembly line operation. However, if he saw mistakes being
made, then he saw to it that the mistakes were corrected. Also,
PPI called him in for assistance “If things were going wrong”.
6
Much of the material in this item F. EAPR’s Manager and
Officers, is based on statements in unsigned declarations by Cruz
and Alvarado, attached to an affidavit submitted by respondent.
Petitioners’ counsel agreed that they would not raise hearsay
objections to these declarations. On brief, petitioners contend
that documents from personnel files which petitioners provided to
respondent would “definitely establish” that Zamora died on Oct.
16, 1993 (not in August 1993), and that Cruz was hired after Oct.
16, 1993 (not 2 weeks before Zamora died). No such personnel
file documents are before us. In any event, the essential thrust
of our conclusions would not be affected by the modifications
that might be required by the above-described personnel file
documents.
- 18 -
Various EA corporate officers served as directors or
corporate officers of EAPR. As with various officers and
directors of other EA affiliates, they were not separately
compensated for serving as officers of EAPR. The compensation
paid to EA’s officers (including those who were officers of EAPR)
was included in EA’s general administrative expense. EA’s
general administrative expense was included in the computation of
the combined profit for purposes of applying the profit split
computation under section 936(h).
G. EAPR’s Finances
EAPR’s cost of goods sold with respect to video games
included direct costs and period costs. Direct costs included
materials and labor. Labor costs included amounts paid to PPI
pursuant to the Agreement. Period costs included materials and
labor for “rework” (a stipulated, but undefined, term).
Table 3 shows EAPR’s total cost of goods sold relating to
the video games it sold to EA, and net sales of video games to EA
(without regard to the profit split allocation under section
936(h)(5)).
Table 3
Fiscal Year Cost of Goods Sold Net Sales
1993 $21,119,356 $22,488,000
1994 56,807,000 59,211,000
1995 76,429,990 79,559,000
1996 42,500,108 45,004,000
- 19 -
II. Discussion
A. In General
Summary judgment is a device used to expedite litigation; it
is intended to avoid unnecessary and expensive trials. However,
it is not a substitute for trial; it should not be used to
resolve genuine disputes over material factual issues. Cox v.
American Fidelity & Casualty Co., 249 F.2d 616, 618 (9th Cir.
l957); Vallone v. Commissioner, 88 T.C. 794, 801 (1987). A
decision will be rendered on a motion for partial summary
judgment if the pleadings, answers to interrogatories,
depositions, admissions, and other acceptable materials, together
with the affidavits, if any, show that there is not any genuine
issue as to any material fact and that a decision may be rendered
as a matter of law. Rule 121(b). A partial summary adjudication
may be made which does not dispose of all the issues in the case.
Id.Because the effect of granting a motion for summary judgment
is to decide the case against a party without allowing that party
an opportunity for a trial, the motion should be “cautiously
invoked” and granted only after a careful consideration of the
case. Associated Press v. United States, 326 U.S. 1, 6 (1945);
Cox v. American Fidelity & Casualty Co., 249 F.2d at 618; Kroh v.
Commissioner, 98 T.C. 383, 390 (1992).
- 20 -
Petitioners, as the moving parties, have the burden of
showing the absence of a genuine issue as to any material fact.
For these purposes, the party opposing the motion is to be
afforded the benefit of all reasonable doubt, and the material
submitted by both sides must be viewed in the light most
favorable to the opposing party; that is, all doubts as to the
existence of an issue of material fact must be resolved against
the movants. E.g., Adickes v. Kress & Co., 398 U.S. 144, 157
(1970); Dreher v. Sielaff, 636 F.2d 1141, 1143 n.4 (7th Cir.
1980); Kroh v. Commissioner, 98 T.C. at 390.
In the instant cases, respondent has not filed any cross-
motion for partial summary judgment. Where, as in the instant
cases, only one side has moved for summary judgment, there is
implicit in the movants’ obligations as to material facts that
the movants have to persuade the Court that they have correctly
identified what facts are material.
Petitioners submitted the affidavits of Richard C. Baker and
J. Everett Milott. Richard C. Baker, a consultant in the early
1990s, describes his role in the establishment of EAPR, the
establishment of the operations in the facility that EAPR leased
from PPI, and the activities of Zamora. J. Everett Milott, PPI’s
executive vice present and general manager when he executed his
affidavit, describes PPI‘s activities from 1992 through 1996 in
connection with the Agreement and the Lease. Respondent
- 21 -
submitted the affidavits of Michael J. Cooper and Dale L. Curren,
and the declaration of Patricia Zentner. Michael J. Cooper
describes the events leading to the unsigned declarations of Cruz
and Alvarado (supra note 6 and accompanying text). Dale L.
Curren, a computer systems analyst with respondent’s Office of
Chief Counsel, describes and furnishes a PPI homepage and PPI
contact page secured at some unstated date, which appears to have
been no earlier than August 4, 1999. Patricia Zentner, an
international examiner for respondent, describes various
documents she sent to, or received from EA (and her notes on
those documents), and various documents showing that certain
paperwork in connection with EAPR activities originated in EA’s
offices in San Mateo, California. For purposes of the instant
partial summary judgment motion, we have treated the statements
as to matters of fact in the Alvarado declaration as though (1)
they accurately describe the events they deal with, and (2) the
events that occurred before Alvarado was hired also were
consistent with these statements--except, of course, to the
extent that the statements are contrary to the parties’
stipulations.
One more preliminary matter: At various points in their
analyses, both sides urge us to follow the “plain meaning” of the
statutes. Of course, each side understands the plain meaning to
be about 180 degrees different from the other side’s view of the
- 22 -
plain meaning. Our reaction is that none of the issues that the
parties have asked us to rule on in the partial summary judgment
motion before us can be resolved by merely looking at the plain
meaning of the statutes we deal with.
We consider first (both dockets) whether petitioners are
entitled to partial summary judgment that EAPR was engaged in the
active conduct of a trade or business in Puerto Rico so as to
entitle it to possessions tax credits for the years in issue. We
then consider (the EAPR docket) whether petitioners are entitled
to partial summary judgment that EAPR had a significant business
presence in Puerto Rico so as to entitle it to compute its
taxable income using the “profit split” method for the years in
issue.
B. Active Conduct of a Trade or Business
1. Parties’ Contentions
Respondent contends that petitioners’ partial summary
judgment motion must be denied because (1) “as a matter of law
* * * Petitioners cannot attribute the activities of the PPI or
EA employees to EAPR” to satisfy the active-conduct-of-a-trade-
or-business test under section 936(a)(2)(B); and (2) if
attribution is not per se impermissible, then “there are material
facts in dispute that are relevant to the statutory” test.
Petitioners contend that the tax credit under section 936,
and the predecessor statutes back to 1921 (which provided an
- 23 -
income tax exemption instead of a credit), “were enacted to
stimulate the creation of jobs and investment in U.S.
possessions, and to provide a tax benefit to taxpayers that
created such jobs and investment.” They urge us to “construe
section 936 in favor of [such] taxpayers” and to “construe
narrowly any limitations on the intended benefits”. Petitioners
further contend that the functions performed by the lease
employees “are properly considered, as a matter of law, to be
functions performed by EAPR in Puerto Rico for purposes of
applying the active trade or business test.” Finally,
petitioners contend that “There are no facts upon which
Petitioners rely that are reasonably in dispute.” Petitioners
further maintain that, even if we were to agree with respondent’s
contentions that certain factual matters are in dispute, these
matters “are not material to a holding by the Court on this issue
[i.e., that EAPR derived income from the active conduct of a
trade or business in Puerto Rico].”
2. Summary of Conclusions
We agree with several of petitioners’ contentions and with
petitioners’ conclusion that their motion for partial summary
judgment on the active-conduct-of-a-trade-or-business issue
should be granted.
The Code does not appear to include a definition of the term
“active conduct of a trade or business” as that term is used in
- 24 -
section 936(a)(1)(A)(i). That term is used in more than 20 other
sections of the Code, and we do not find a statutory definition
for that term as used in any of these other sections. Code
provisions generally are to be interpreted so congressional use
of the same words indicates an intent to have the same meaning
apply, and congressional use of different words indicates an
intent to have a different meaning apply. Under these
circumstances, authoritative interpretations of that term as used
in other provisions of the Code may be regarded as proper
precedent for interpreting that term as used in section 936(a).
In particular, we focus on opinions interpreting that term in the
Western Hemisphere Trading Corporations context, and on Treasury
Regulations interpreting that term in the context of sections
179, 355, and 367. Applying our analysis in MedChem (P.R.), Inc.
v. Commissioner, 116 T.C. 308 (2001), on appeal (1st Cir., Aug.
24, 2001), and the interpretations in Western Hemisphere Trading
Corporations cases to the factual matters established by the
parties’ stipulations, pleadings, affidavits, etc., we conclude
that EAPR’s activities amounted to the active conduct of a trade
or business in Puerto Rico, within the meaning of section 936(a),
during the years in issue.
We conclude that respondent’s contentions as to disputes
over factual matters are all (1) contradicted by the stipulations
or pleadings, or (2) immaterial, or (3) both.
- 25 -
We hold, for petitioners, that they are entitled to the
partial summary judgment they seek on this issue.
3. Analysis
Section 936(a)7 provides that if a qualified domestic
7
Sec. 936(a) provides, in pertinent part, as follows:
SEC. 936. PUERTO RICO AND POSSESSION TAX CREDIT.
(a) Allowance of Credit.–-
(1) In general.–-Except as otherwise provided in
this section, if a domestic corporation elects the
application of this section and if the conditions of
both subparagraph (A) and subparagraph (B) of paragraph
(2) are satisfied, there shall be allowed as a credit
against the tax imposed by this chapter [chapter 1,
relating to normal taxes and surtaxes] an amount equal
to the portion of the tax which is attributable to the
sum of–-
(A) the taxable income, from sources without
the United States, from–-
(i) the active conduct of a trade or
business within a possession of the United
States, or
(ii) the sale or exchange of
substantially all of the assets used by the
taxpayer in the active conduct of such trade
or business, and
(B) the qualified possession source
investment income.
(2) Conditions which must be satisfied.–-The
conditions referred to in paragraph (1) are:
(A) 3-year period.–-If 80 percent or more of
the gross income of such domestic corporation for
the 3-year period immediately preceding the close
of the taxable year (or for such part of such
period immediately preceding the close of such
(continued...)
- 26 -
corporation elects to have section 936 apply, then that
corporation is entitled to a credit against its income tax. One
requirement for such treatment, as applied to the instant cases,
is that EAPR have derived at least 75 percent of its gross
income8 “from the active conduct of a trade or business within
* * * [Puerto Rico]”.
Section 936 does not define the term “active conduct of a
trade or business”. As far as we can tell, the Code does not
include a definition of this term as it is used in section 936.
7
(...continued)
taxable year as may be applicable) was derived
from sources within a possession of the United
States (determined without regard to section
904(f)); and
(B) Trade or business.–-If 75 percent or more
of the gross income of such domestic corporation
for such period or such part thereof was derived
from the active conduct of a trade or business
within a possession of the United States.
Sec. 13227(a)(1) of the Omnibus Budget Reconciliation Act of
1993 (OBRA 1993), Pub. L. 103-66, 107 Stat. 321, 489, amended
sec. 936(a)(1) by striking “as provided in paragraph (3)” and
inserting “as otherwise provided in this section”. Although this
amendment applies to taxable years beginning after Dec. 31, 1993,
the amendment does not affect the substance of the above-quoted
portion of sec. 936(a). OBRA 1993, sec. 13227(f), 107 Stat. at
494. Thus, we have quoted sec. 936(a)(1) as amended by OBRA
1993.
8
The dispute the parties have presented to us does not focus
on the numbers. Accordingly, our analysis deals with the quality
of the activity, and not with the amount or percentage of EAPR’s
gross income from the activity.
- 27 -
The term “active conduct of a trade or business” appears in
22 sections of the current version of the Code. MedChem (P.R.),
Inc. v. Commissioner, 116 T.C. at 330. Ordinarily, we would
expect that this term would have the same meaning in all the
places it appears. United States v. Cleveland Indians Baseball
Co., 532 U.S. 200, 213 (2001); Commissioner v. Keystone Consol.
Industries, Inc., 508 U.S. 152, 159 (1993); United States v.
Olympic Radio & Television, 349 U.S. 232, 236 (1955); Zuanich v.
Commissioner, 77 T.C. 428, 442-443 (1981), and cases there
cited.9 However, none of the other Code provisions includes a
9
This is the general rule not only because of the authority
of the cited opinions, but also because this is the way
legislative drafters are instructed to draft statutes. See,
e.g., Office of the Legislative Counsel U.S. House of
Representatives, Style Manual; Drafting Suggestions for the
Trained Drafter, 3 (1989), as follows:
(4) Use same word over and over.--If you have
found the right word, don’t be afraid to use it again
and again. In other words, don’t show your pedantry by
an ostentatious parade of synonyms. Your English
teacher may be disappointed, but the courts and others
who are straining to find your meaning will bless you.
(5) Avoid utraquistic subterfuges.--Do not use the
same word in 2 different ways in the same draft (unless
you give the reader clear warning).
To the same effect, see Dickerson, The Interpretation and
Application of Statutes 224 (1975), quoted in Zuanich v.
Commissioner, 77 T.C. 428, 443 n.26 (1981), as follows:
26
See R. Dickerson, The Interpretation and
Application of Statutes 224 (1975), as follows:
Because legal documents are for the most part
(continued...)
- 28 -
statutory definition of this term. Also, as far as we can tell,
nowhere else in the Code is there a definition of this term as it
is used in section 936 or in any of the other Code sections in
which this term is used.
In MedChem (P.R.), Inc. v. Commissioner, 116 T.C. at 333, we
pointed out that “the roots of that section [936] are found in
section 262 of the Revenue Act of 1921”, and we briefly
summarized the purpose and history of the statute in accordance
with our analyses in G.D. Searle & Co. v. Commissioner, 88 T.C.
252, 350-351 (1987), and Coca-Cola Co. & Subs. v. Commissioner,
106 T.C. 1, 21 (1996). From section 262 of the Revenue Act of
1921 through section 931, I.R.C. 1954, a qualifying domestic
corporation was exempt from Federal income taxes on certain
9
(...continued)
nonemotive, it is presumed that the author’s language
has been used, not for its artistic or emotional
effect, but for its ability to convey ideas.
Accordingly, it is presumed that the author has not
varied his terminology unless he has changed his
meaning, and has not changed his meaning unless he has
varied his terminology; that is, that he has committed
neither “elegant variation” nor “utraquistic
subterfuge”. This is the rebuttable presumption of
formal consistency. [Fn. refs. omitted.]
In United States v. Cleveland Indians Baseball Co., 532 U.S.
200, 213 (2001), the Supreme Court made it clear that there are
some circumstances where “‘the meaning [of the same words] well
may vary to meet the purposes of the law,’” quoting Atlantic
Cleaners & Dyers v. United States, 286 U.S. 427, 433 (1932). It
does not appear that the circumstances dealt with in Cleveland
Indians have a persuasive parallel as to the active-conduct-of-a-
trade-or-business issue. However, see infra II. C. for
discussion of the term “manufactured or produced”.
- 29 -
foreign-source income. In the Tax Reform Act of 1976, the
Congress eliminated the exemption and in its place enacted the
credit mechanism of section 936. Tax Reform Act of 1976, Pub.L.
94-455, sec. 1051, 90 Stat. 1520, 1643. Section 936 uses, and
each of these predecessors used, the term “active conduct of a
trade or business”. See MedChem (P.R.), Inc. v. Commissioner,
116 T.C. at 333-336. Also in accordance with the general
interpretation rule that statutory language should be given the
same meaning wherever it appears, we reviewed the regulations
interpreting “active conduct of a trade or business” in sections
1.179-2(c)(6), Income Tax Regs., 1.355-3(b)(2), Income Tax Regs.,
and 1.367(a)-2T(b), Temporary Income Tax Regs., 51 Fed. Reg.
17942 (May 15, 1986). Id. at 330-333. Synthesizing the
foregoing, we concluded as follows, id. at 336-337:
On the basis of our understanding of the legislative
record, we believe that Congress promulgated the “active
conduct of a trade or business” requirement of section
936(a) intending to prevent a domestic corporate taxpayer
from availing itself of the possessions tax credit unless it
established and regularly operated an employment-producing,
profit-motivated business activity in a U.S. possession. We
also believe that Congress expected the taxpayer to
participate meaningfully in the management and operation of
that activity and to invest significantly in that activity,
the expected result of which would be to strengthen the
economy of the possession where the activity was located. In
light of Congress’ intent for section 936, the Secretary’s
interpretations of the subject phrase for purposes of other
sections of the Code, and the Supreme Court’s interpretation
of the phrase “trade or business” in section 162(a), we
believe 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-
- 30 -
motivated activity in that possession. Cf. Commissioner v.
Groetzinger, 480 U.S. [23,] 26 [(1987)]; Higgins v.
Commissioner, 312 U.S. [212,] 217 [(l941)]; Stanton v.
Commissioner, 399 F.2d 326, 329-330 (5th Cir. 1968), affg.
T.C. Memo. 1967-137. We also believe that, for 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 taxpayer’s own employees.
Another source of guidance may be found in the
interpretation of “active conduct of a trade or business” in the
provisions dealing with Western Hemisphere Trading Corporations,
hereinafter sometimes referred to as WHTCs. The WHTC provisions
existed in the Code for a substantial portion of the history of
section 936 and its predecessors. The WHTC provisions were
enacted by sections 105(b) and 141 of the Revenue Act of 1942 as
sections 15(b) and 109, I.R.C. 1939. Pub. L. 77-619, 56 Stat.
798, 806, 838. Under these provisions, a domestic corporation
qualified for the WHTC exemption only if (1) all of its business
was conducted in the Western Hemisphere, (2) it derived at least
95 percent of its gross income from sources outside the United
States, and (3) it derived at least 90 percent of its gross
income “from the active conduct of a trade or business.” Sec.
109(b), I.R.C. 1939.
WHTCs were exempt from the corporate surtax until the
Revenue Act of 1950, Pub. L. 81-994, 64 Stat. 906, 915, 920,
which replaced the exemption (sec. 121(c) of the Act) with a
credit computed as a specified percentage of normal-tax net
- 31 -
income. Sec. 122(c) of the Act. The Internal Revenue Code of
1954 substituted for this a formula deduction resulting in a 14-
percentage-point tax rate reduction. See sec. 922, I.R.C. 1954.
The WHTC provisions, I.R.C. 1954 secs. 921 and 922, were repealed
by sec. 1052(b) of the Tax Reform Act of 1976, Pub. L. 94-455, 90
Stat. 1520, 1648.
Several opinions of this and other courts have noted the
general similarity of congressional purpose between the
possessions corporations provisions and the WHTC provisions. In
view of the WHTC provisions’ use of the term “active conduct of a
trade or business”, we believe that opinions interpreting that
term as used in the WHTC provisions are helpful in interpreting
the same term in section 936(a). As we see it, the WHTC opinions
are essentially consistent with the analysis in MedChem (P.R.),
Inc. v. Commissioner, supra.
Section 936(a)(2)(B) requires that 75 percent of the gross
income of the qualifying corporation (in the instant cases, EAPR)
be “derived from the active conduct of a trade or business within
a possession of the United States”, in the instant cases, Puerto
Rico. In comparison, the effect of the WHTC provisions was to
require that at least 90 percent of the gross income of the
qualifying corporation had been derived “from the active conduct
of a trade or business” in the Western Hemisphere outside of the
United States.
- 32 -
Petitioners direct our attention primarily to the following
WHTC opinions: Frank v. International Canadian Corp., 308 F.2d
520 (9th Cir. 1962); Babson Brothers Export Co. v. Commissioner,
T.C. Memo. 1963-144. Respondent contends that “Cases arising
under * * * [the WHTC provisions] are not applicable to a section
936 issue” (a contention we reject), and urges us to focus on
“the contrary holding in another section 921 case, United States
Gypsum Company v. United States”, 304 F. Supp. 627 (N.D. Ill.
1969), affd. in part and revd. in part 452 F.2d 445 (7th Cir.
1971).
Frank v. International Canadian Corp., supra, involved the
following situation. A, a U.S. corporation, owned B, also a U.S.
corporation. B produced liquid chlorine and liquid caustic soda,
which it sold to C, a Canadian corporation. For what the
District Court found and what the Court of Appeals accepted were
“good business reasons” (id. at 526), B created D to handle sales
to C. Thereafter, B sold its products to D, which then sold them
to C. The Commissioner determined that D did not qualify as a
WHTC. After losing across-the-board in a refund suit in the
District Court, the Commissioner contended on appeal that D did
not qualify as a WHTC because it did not derive the requisite
gross income “‘from the active conduct of a trade or business’
within the meaning of section 109(b) of the Internal Revenue Code
- 33 -
of 1939”. Id. at 524. The Court of Appeals summarized the
relevant facts as follows, id. at 523:
[D] had its own invoices, letterheads, and employer
social security number; it maintained separate books of
account and it maintained its bank account at a bank
different from that used by [B]; it underwent a separate
annual audit by certified public accountants and it filed
separate corporate income tax returns. And it had officers
and directors differing from those of [B]; its officers and
directors did, however, hold official positions with either
[B] or [A].
[D] paid one employee, Mr. Nielson, directly. Mr.
Nielson was responsible for [D’s] administrative work. The
work consisted of maintaining [D’s] books and records;
reviewing all paper work done by the personnel of [B] who
had been assigned to assist him; preparing export
declarations and customs papers; handling correspondence;
and coordinating instructions received from [C] with [B’s]
traffic, production, and shipping departments. During its
first year of operations, [D] paid [B] $100 a month for the
assistance and facilities provided by [B]; after the first
year was completed, a study was made and [D’s] monthly
payment to [B] was increased to $200.
After 1952 [D] paid Dr. William Cooper a fee to study
the possibility of expanding [D’s] business in the Canadian
market.
The Court of Appeals ruled that these facts were sufficient
to constitute the active conduct of a trade or business by D,
even though the employees of B, the parent corporation, performed
all the work other than that performed by D’s one employee. Id.
at 526-527. The taxpayer qualified for WHTC treatment.
In Babson Brothers Export Co. v. Commissioner, supra, we
quoted extensively from the opinion in Frank v. International
Canadian Corp., supra, and relied on the latter opinion’s
conclusions to hold that the taxpayer in Babson Brothers Export
- 34 -
Co. was in the active conduct of a trade or business, and
qualified for WHTC treatment.
In Kewanee Oil Co. v. Commissioner, 62 T.C. 728, 737-738
(1974), we described as follows the essential thrust of the
foregoing cases and the significance of “active conduct of a
trade or business”:
Although the statutory history of the Western
Hemisphere trade corporation provisions is perhaps less
exhaustive than might be desired, we think it nonetheless
discloses a clearly articulated legislative purpose upon the
basis of which Congress enacted the provisions in question.
The critical policy which emerges in the Western Hemisphere
provisions, and as previously expressed in the Revenue Acts
of 1921 and 1940, was Congress’ desire to offset through a
tax preference the competitive disadvantage suffered by
certain American corporations abroad on account of the less
onerous taxes to which their non-American competitors were
subject. This encouragement was not, however, without
limitations. By means of the source rule and the active
conduct requirement Congress quite apparently sought to
distinguish, however bluntly, between those corporations
which themselves engaged in business activity outside the
United States in direct competition with foreign
corporations and those which merely invested in others’
businesses abroad or otherwise did not engage in directly
competitive activity. Our understanding in this respect is
not different from that expressed by the few courts which
have had occasion to address themselves to the language of
this portion of the statute. Cf. Frank v. International
Canadian Corporation, 308 F.2d 520, 525 (C.A. 9);13 Towne
Securities Corporation v. Rea Forhan Pedrick, 44 A.F.T.R.
1258, 1259 (S.D. N.Y.); Babson Bros. Export Co., 22 T.C.M.
677, 683-684. It follows that when the “active conduct”
requirement is read in the context from which it arose,
namely the threat of foreign competition, one might well
conclude that in passing the Western Hemisphere provisions
Congress intended to grant relief to United States business
activity in the Americas only to the extent that the
beneficiary corporation conducted active business operations
abroad vulnerable to the competitive threat posed by the
tax-advantaged corporation of the other countries.14
- 35 -
13
It is quite true that the court in the International
Canadian case stated (p. 525) that the active conduct
requirement “is to disqualify corporations which are
‘inactive’ in the sense that they receive investment income
rather than business income.” But that statement was made
in the context of a situation where the taxpayer was engaged
regularly and actively in the business of making sales in
Canada, and the income in question was derived from such
sales. The court obviously did not give any consideration
to the applicability of the statute to an isolated
transaction of the type before us, and we do not give that
language the possible expansive reading that would include
such a transaction within the “active conduct” clause.
14
This understanding of the statutes’ purpose conforms well
to the Commissioner’s position that interest income, which
would otherwise constitute “passive” income outside the
purview of sec. 921(2), meets the “active conduct”
requirement when received from the taxpayer’s customers on
account of their credit obligations arising from the regular
and recurring conduct of the taxpayer’s business. Rev. Rul.
65-290, 1965-2 C.B. 241.
In Kewanee Oil Co. v. Commissioner, 62 T.C. at 738, we held
that the taxpayer’s income from the sale of “substantially all of
its oil- and gas-producing property and associated equipment, the
source of virtually its entire revenues until that time” was
derived from the termination of the major portion of its
business and not from the active conduct thereof;
accordingly, * * * [the taxpayer] did not meet the “active
conduct” requirement set forth in section 921 and was
therefore not entitled to the deduction provided in section
922. [Id. at 739.]
In United States Gypsum Co. v. United States, 304 F. Supp.
at 642-643, the opinion upon which respondent relies, the
District Court discussed approvingly the opinion of the Court of
Appeals for the Ninth Circuit in Frank v. International Canadian
Corp., supra. The District Court then contrasted the factual
- 36 -
setting of Frank v. International Canadian Corp., supra, with its
own findings and conclusions based on the record before it, as
follows (304 F. Supp. at 643):
Clear from a reading of the Frank rationale and holding is
that the subsidiary there took over business previously
performed by the parent. The parent transferred its selling
operations to the subsidiary. The court further found there
that the subsidiary was not “inactive”:
“The facts also show clearly that International earned
its income by performing services. International
resolved shipping problems with Alaska Pine; it handled
all the export declarations and customs papers; it
incurred and paid $124,814.72 in freight charges; it
was studying the possibility of expanding its business
in Canada. In the words of the district court:
“* * * in entire good faith International was
organized as a corporation and at all times
operated as a bona fide separate entity engaged in
substantial and legitimate business activities
from which its gross income was derived.” (308
F.2d at 527)
In its dealings with the affiliate mining companies
Export performed no services; resolved no problems; incurred
no freight charges; and engaged in no genuine business
activities.
I therefore find and conclude that the portion of its
income derived from the purchase of crude gypsum from its
sister companies and the resale to its parent was not income
derived from the active conduct of a trade or business
within the meaning of section 921 (26 U.S.C. §921). I
further find and conclude that for this reason Export did
not qualify as a Western Hemisphere Trade Corporation and
was not entitled to claim the benefits of the special
deductions under the Act.
Thus, the opinion in United States Gypsum Co. v. United
States, supra, was not thought by the District Court as being
“contrary” to the rationale of Frank v. International Canadian
- 37 -
Corp., supra. Rather, the difference in relevant facts in those
two cases led to the difference in result.
In the instant cases, EAPR (1) bought, from unrelated
sellers, and owned all the equipment used in Puerto Rico to
manufacture the video games; (2) bought, from unrelated
suppliers, and owned all the raw materials and components used in
Puerto Rico to manufacture the video games; and (3) was lessee of
the facilities in Puerto Rico in which the equipment and the raw
materials and components were used in Puerto Rico in
manufacturing the video games. EAPR’s manager lived in Puerto
Rico and worked in the leased space; he supervised PPI employees
in charge of managing materials and inventory control and saw to
it that assembly line mistakes were corrected. The role that
EAPR played regarding video game manufacturing in Puerto Rico was
much more like what the taxpayer did in Frank v. International
Canadian Corp., supra, than what the taxpayer did in United
States Gypsum Co. v. United States, supra.
In MedChem (P.R.), Inc. v. Commissioner, 116 T.C. at 337-
343, we discussed the factual elements that, in the aggregate,
led us to conclude that the taxpayer-subsidiary therein was not
in the active conduct of a trade or business in Puerto Rico
during the statutorily relevant 3-year time period.10 Although
10
See MedChem (P.R.), Inc. v. Commissioner, 116 T.C. 308,
340 (2001), where we noted that “Some of the activities listed by
[the taxpayers] preceded the 3-year period, and very few of the
(continued...)
- 38 -
the general fact pattern of the instant cases has some
similarities to that in MedChem, the aggregate of the differences
between the facts of MedChem and the facts of the instant cases
convinces us that the instant cases fall on the other side of the
line; i.e., that EAPR actively conducted a trade or business in
Puerto Rico during the relevant time period. With the caution
that our conclusion is based on the aggregate of the differences
between the instant cases and MedChem; i.e., that no one
difference is critical by itself, we proceed to describe the
significant differences.
In MedChem, the taxpayers had acquired from an unrelated
entity the assets of a Puerto Rican business that manufactured
and sold a specific pharmaceutical (hereinafter sometimes
referred to as the drug). MedChem (P.R.), Inc. v. Commissioner,
116 T.C. at 314. The assets were divided between taxpayer-parent
and taxpayer-subsidiary; the subsidiary is the corporation that
was claimed to qualify for the possession tax credit under
section 936(a). Id. at 314, 327. The taxpayer-parent got
receivables, several noncompetition agreements, goodwill,
contract rights, records, patents and related know-how,
trademarks, and Food and Drug Administration approvals. Id. at
10
(...continued)
other listed activities occurred continually throughout that
period.” In the instant cases, it appears that all of the
activities that we discuss occurred during the relevant test
period.
- 39 -
314-315. The taxpayer-subsidiary got receivables, inventory, and
machinery and equipment located in the unrelated entity’s
manufacturing facility. Idem.
As part of the sale, the unrelated entity agreed to continue
manufacturing the drug for the taxpayer-subsidiary using the
unrelated entity’s facility and labor, and using the raw
materials and equipment furnished by the taxpayer-subsidiary.
Id. at 316. We found that the employees of the unrelated entity
“performed every task required in the manufacturing process,
including the supervision thereof, * * * without the right or
ability of * * * [the taxpayers] to manage, direct, or control
any part of the manufacturing process.” Id. at 339. Indeed,
except for the MedChem cases themselves, the taxpayers had
consistently reported in all instances that the unrelated entity
was the drug’s manufacturer. Id. at 340. As a reflection of
this, the labels which the taxpayer-subsidiary used during one of
the years at issue in MedChem designated the unrelated entity as
the manufacturer of the drug. Id. at 315-316. We concluded that
all of the business activities related to the manufacture of the
drug were directed and controlled by the unrelated entity out of
its Puerto Rico-based operation, and by the taxpayer-parent, out
of its U.S.-based facility. Id. at 338.
The taxpayer-parent distributed, marketed, and sold the drug
in the United States. Id. at 339. We found that the taxpayer-
subsidiary “was expressly prohibited by the processing agreement
- 40 -
from taking a managerial role in the manufacturing process.” Id.
at 342. We concluded that the substance of the work as to the
manufacturing of the drug, which required specialized skill and
expertise, was performed by the unrelated entity. Id. at 343.
The facts of the instant cases are distinguishable from
those in MedChem in several material respects.
In MedChem, before the acquisition described supra, the
unrelated entity manufactured the drug in Puerto Rico, and the
taxpayer-parent did not have anything to do with the drug. Id.
at 310-311, 314. After this acquisition, the unrelated entity
continued to manufacture the drug at its own facility with its
own labor and was solely responsible for any problem that arose
up to the time the finished product was delivered to a carrier
for shipment to the taxpayer-parent. Id. at 317. Thus, although
the acquisition affected ownership, it did not affect what
happened “on the ground” in Puerto Rico. In contrast, in the
instant cases, EA was in the entertainment software business and
relied on unrelated manufacturers in Taiwan and Japan. After
EAPR was created, the entertainment software was manufactured in
Puerto Rico, using facilities and labor that PPI leased to EAPR,
and using equipment that EAPR bought from unrelated sellers.
Thus, the arrangements following the creation of EAPR created an
entirely new business in Puerto Rico, using facilities, labor,
and equipment that had not previously been used in this business.
In contrast to MedChem, what happened “on the ground” in Puerto
- 41 -
Rico in the instant cases was substantially different from the
past.
In MedChem, we concluded that the taxpayer-subsidiary’s
“business presence” in Puerto Rico was insignificant in
that it did not contribute significantly to Puerto
Rico’s economy either by creating new jobs or by
providing capital to others to build new plants. * * *
All of * * * [the taxpayer-subsidiary’s] business
activities after June 30, 1990, were based in Woburn,
* * * [Massachusetts,] and * * * [the taxpayers’]
primary connection to Puerto Rico during that time was
to further its efforts to move the manufacturing of
* * * [the drug] to Woburn * * *. Id. at 338-339.
In contrast, in the instant cases, the effect of EAPR’s
operations was to transfer to Puerto Rico the manufacturing
operations that had hitherto been performed almost halfway around
the world.
In MedChem, we found that the taxpayer-subsidiary “was
expressly prohibited by the processing agreement from taking a
managerial role in the manufacturing process.” Id. at 342. In
contrast, in the instant cases, PPI and EAPR agreed that (1) all
the lease employees “shall be under the general supervision of
EAPR”, and (2) “EAPR shall also supervise and control all
technical and product-related training required by” the lease
employees. The parties’ stipulations make it clear that the EAPR
manager position was filled “at all times during the years at
issue” by “a manager who * * * worked in the leased space covered
by the Lease” and who was compensated by EAPR. See supra table
2. Also, it is evident that Alvarado directly supervised PPI
- 42 -
employees as to certain parts of the manufacturing process. He
was not a foreman for PPI’s assembly line employees, nor did he
hire and fire them. However: (1) He made sure that mistakes were
corrected; (2) he “[watched] out for EA’s interests” as to the
assembly work; and (3) “If things were going wrong [as to the
assembly line], then PPI would call me in for assistance.”
In MedChem (P.R.), Inc. v. Commissioner, 116 T.C. at 338
n.14, we stated as follows:
14
We distinguish Frank v. International Canadian Corp., 308
F.2d 520 (9th Cir. 1962), a case cited by petitioners to
support their assertion that MedChem P.R. actively conducted
a trade or business by virtue of its sales activity. The
relevant holding in Frank concerned whether the taxpayer
actively conducted a trade or business and did not concern
where that trade or business was located.
In the instant cases, EAPR’s activities in Puerto Rico with
respect to the video games are critically different from the
taxpayer’s activities in MedChem (P.R.), Inc. v. Commissioner,
supra (where the taxpayer’s only activities in Puerto Rico were
the taking of steps to move the business from Puerto Rico to
Massachusetts), and Kewanee Oil Co. v. Commissioner, supra (where
substantially all the taxpayer’s relevant income was derived from
the sale of substantially all the taxpayer’s relevant business).
Our findings (supra I.F.) lead us to conclude that EAPR,
through its manager, participated regularly, continually,
extensively, and actively in the management and operation of the
manufacturing of video games in Puerto Rico.
- 43 -
In view of the foregoing, we conclude that EAPR actively
conducted a trade or business in a U.S. possession within the
meaning of section 936(a)(2)(B).
4. Respondent’s Other Contentions
a. Genuine Issues of Material Fact
i. Place of Manufacture
Respondent contends as follows on opening brief:
2. There is a factual dispute as to where the video
games were manufactured. * * * Whether video
games were manufactured in the Dominican Republic
or Puerto Rico is a crucial factor in ascertaining
whether EAPR was engaged in the active conduct of
a trade or business in Puerto Rico.
On answering brief, respondent objects to petitioners’ proposed
finding of fact that “The video games at issue that EA purchased
from EAPR were manufactured in Puerto Rico. [Stip. ¶ 27]”, as
follows:
22. Objection. The evidence establishes that the
video games that EA purchased from EAPR were manufactured by
PPI employees in PPI’s Dominican Republic facilities as well
as in PPI’s Puerto Rico facilities. See RRPSOF ¶ 17.
However, the parties stipulated as follows: “27. The video
games at issue that EA purchased were manufactured in Puerto
Rico.” Note that respondent does not contend that EA bought the
video games from PPI; respondent accepts petitioners’ contention
that EA bought the video games from EAPR. Respondent’s only
objection is as to the geographic location of the manufacturing--
the very point that the parties resolved by their stipulation.
- 44 -
Rule 91(e) provides, in pertinent part, as follows:
(e) Binding Effect: A stipulation shall be
treated, to the extent of its terms, as a conclusive
admission by the parties to the stipulation, unless
otherwise permitted by the Court or agreed upon by
those parties. The Court will not permit a party to a
stipulation to qualify, change, or contradict a
stipulation in whole or in part, except that it may do
so where justice requires. * * *
Respondent has not asked to be relieved from this
stipulation, and nothing that has been brought to the Court’s
attention leads us to conclude that justice requires us, sua
sponte, to relieve respondent from this stipulation. Compare the
instant cases with, e.g., BankAmerica Corp. v. Commissioner, 109
T.C. 1, 12 (1997) (where we concluded that, in the interest of
justice, the taxpayer should be relieved from the effects of a
stipulation, but only for a specified “narrow purpose”); Stamos
v. Commissioner, 87 T.C. 1451, 1454-1456 (1986) (where we
“concluded that the language in question from the stipulation
filed herein is so ambiguous and indefinite that it does not
constitute a stipulation at all”, and thereupon denied a motion
for partial summary judgment).
Respondent explains the stipulation as follows:
The stipulations listed by Petitioners do not preclude
evidence that part of the games were manufactured elsewhere,
e.g., the Dominican Republic, since they refer only to what
has taken place in Puerto Rico and do not address activities
outside Puerto Rico.
The effect of this explanation is to treat Stipulation 27 as
though it read as follows:
- 45 -
27. The video games at issue that EA purchased were
manufactured in Puerto Rico, except to the extent they were
manufactured in the Dominican Republic.
We refuse to allow respondent to unilaterally reform the
filed stipulation in this matter. We do not accept respondent’s
unilateral explanation that the stipulation means so much less
than it appears to mean.
We conclude that there is no genuine issue as to the
material fact of Puerto Rican manufacture of the relevant video
games.
ii. Control Over Manufacturing Process
Respondent contends as follows:
3. There is a factual dispute as to whether EAPR had any
control over the manufacturing process. According to
Alvarado, there were significant conflicts between EA
and PPI because EA did not want the video games to be
manufactured at PPI’s plant in the Dominican Republic.
Alvarado Decl. ¶¶ 34-35. The manufacturing was done by
PPI workers in the Dominican Republic because it was
cheaper. Alvarado Decl. ¶ 22. Obviously, if EA (or
EAPR) had been in control of the manufacturing process,
the video games would not have been manufactured in the
Dominican Republic by PPI against EA’s wishes. Whether
EAPR had any control over the manufacturing process is
directly related to the issue of whether EAPR
controlled and supervised the PPI employees. [Fn. ref.
omitted.]
This asserted genuine issue of material fact is bottomed on
the contention of Dominican Republic manufacture. As we have
pointed out supra, i. Place of Manufacture, the parties’
stipulation has foreclosed this contention. Thus, this
- 46 -
contention as to EAPR’s control over the manufacturing process is
not a genuine issue as to a material fact.
iii. Supervision Over Lease Employees
Respondent contends as follows:
1. There is a factual dispute as to whether the one EAPR
employee (i.e., Willie Zamora, Jose Cruz, or Miguel
Orlando Alvarado) supervised or controlled the PPI
employees who manufactured the video games or the EA
employees who performed all of EAPR’s daily operations.
Respondent relies primarily on Alvarado’s declaration, which
respondent offered in support of respondent’s opposition to
petitioners’ motion. Alvarado’s declaration indicates that he
was EAPR’s manager for most of the period before the Court.
Alvarado’s declaration states that
(1) he oversaw the transferring of raw materials, work
in process, and finished goods, and in this capacity he “had
two or three PPI employees under me in the materials
management function”; and
(2) he--
also oversaw the PPI employees who worked on inventory
control, which meant that I had to make sure that they were
doing the cycle counts and that they entering [sic] the
correct data onto paper inventory reports. I was
responsible for entering the data into the computer. I
oversaw that the correct data was entered into the computer
for [MRP System] on the Puerto Rican end. * * *
In general I did not deal directly with assembly line
operation, since this was handled by PPI. However, if I saw
a mistake being made, then I would see that it got
corrected. My basic function in regard to the assembly work
was to watch out for EA’s interests. However, PPI handled
the daily production requirements and PPI scheduled the
- 47 -
employees, assigned positions to them, handled things on the
assembly floor, took care of sick leave and other personnel
problems. If things were going wrong, then PPI would call
me in for assistance. Otherwise, PPI handled everything.
Respondent also relies on Cruz’ declaration, which is as
follows, in entirety:
1. I reside at Calle Leonor AV 21, 4th Extension,
Levittown Lakes, Puerto Rico 00949.
2. I was employed by Electronic Arts Puerto Rico for a
period of 3 ½ weeks in the summer of 1993.
3. I was hired about two weeks before the death of Mr.
Zamora as his assistant.
4. I never held the position of General Manager nor did I
ever carry out the duties of General Manager.
5. The focus of my work as assistant to Mr. Zamora was
with inventory control, particularly counting
inventory, communicating with Electronic Art [sic] in
California in regard to inventory needs, and I also had
some responsibilities with regard to shipping.
6. My employment was terminated 1 ½ weeks after Zamora
died.
Respondent further contends that “Absent first hand evidence
of the business practices prior to Cruz and Alvarado, Respondent
is entitled to the inference that the same business practices
were in effect while Zamora was employed at EARP [sic].”
As we have noted supra (in note 6, and in the description in
II. A. In General, of the affidavits and declarations that the
parties submitted), for purposes of the instant partial summary
judgment motion, we have treated the statements as to matters of
fact in the Alvarado declaration as though (1) they accurately
- 48 -
describe the events they deal with, and (2) the events that
occurred before Alvarado was hired were consistent with these
statements--except, of course, to the extent that the statements
are contrary to the parties’ stipulations. We give little weight
to the Cruz declaration’s account of the 2 weeks when he was
Zamora’s assistant and the 1-1/2 weeks after Zamora’s death.
We conclude from the foregoing that, for the period before
the Court, EAPR’s employees provided substantial supervision to
the PPI employees (the lease employees) who did the video game
manufacturing for EAPR in Puerto Rico. Although there is room
for further factual development, the material offered by
respondent leads us to the conclusion that, if any such
development were to show us that respondent’s proffered materials
fully and accurately described the facts, then we would conclude
that the supervision requirement of MedChem has been satisfied.
In other words, on this issue, petitioners win on the facts
as described in respondent’s materials. Thus, although there may
be a genuine issue as to the extent of EAPR’s supervision of the
manufacturing process, there is not a genuine issue as to a
material fact with regard to EAPR’s qualification for possession
tax credits for the years in issue.
- 49 -
b. EAPR Ineligible As a Matter of Law
i. WHTC Cases
Respondent contends that “Cases arising under section 921
and 922 [the Western Hemisphere Trade Corporation provisions] are
not applicable to a section 936 issue. See Norfolk Southern
Corp. [v. Commissioner,] 104 T.C. [13] at 41 [(1995)].”
Firstly, the cited opinion, Norfolk S. Corp. v.
Commissioner, 104 T.C. 13, modified 104 T.C. 417 (1995), affd.
140 F.3d 240 (4th Cir. 1998), neither states nor stands for the
proposition for which respondent cites it. The cited opinion
does not even involve or cite sections 921, 922, or 936 or their
predecessors.11
11
Norfolk S. Corp. v. Commissioner, 104 T.C. 13, modified
104 T.C. 417 (1995), affd. 140 F.3d 240 (4th Cir. 1998), was an
investment credit case; it did not involve the WHTC provisions or
the possession tax credit provisions. Respondent directs our
attention to Norfolk S. Corp. v. Commissioner, 104 T.C. at 41.
That page is part of our analysis of the taxpayer’s contention
that “used” in the phrase “used in the transportation of
property” in sec. 48(a)(2)(B)(v), must be given the same meaning
as in the phrase “used in the trade or business” in sec.
167(a)(1). We concluded that, in the context of sec.
48(a)(2)(B)(v), it made sense to give “used” a different meaning
from “used” in the context of sec. 167(a)(1). We buttressed our
conclusion as follows, Norfolk S. Corp. v. Commissioner, 104 T.C.
at 40 n.30:
30
We note in further support of our rejection of
petitioners’ interpretation of the container exception that
in sec. 48(a)(2)(B)(v) Congress employed the phrase “used in
the transportation of property”, not “used in the trade or
business of transporting property”. “The use of different
phrases may reasonably be viewed as an indication of two
different meanings.” Pavelic & LeFlore v. Marvel
(continued...)
- 50 -
Secondly, respondent’s brief does not present to us, or
direct our attention to, an analysis to support the proposition
that WHTC opinions “are not applicable to a section 936 issue.”
Thirdly, as opinions of this and other courts have shown,
the histories of WHTC legislation and possessions corporation
legislation have been intertwined for the entire history of the
WHTC provisions. See, e.g., Kewanee Oil Co. v. Commissioner, 62
T.C. 728, 735-738 (1974), and opinions cited therein, affd.
without published opinion 517 F.2d 1398 (3d Cir. 1975) (a WHTC
“active conduct of a trade or business” case in which the 1921
Act predecessor of section 936 is described as having “laid the
conceptual groundwork,” for, among other provisions, the WHTC
provisions); Burke Concrete Accessories, Inc. v. Commissioner, 56
T.C. 588, 596-599 (1971), and opinions cited therein (a
consolidated return case in which a section 1504(b)(4) reference
to section 931 is construed by taking into account the agreement
of the parties that the corporation there involved was both a
WHTC and a possessions corporation). This intertwining of
11
(...continued)
Entertainment Group, 493 U.S. 120, 128 (1989) (Marshall, J.,
dissenting); see also LaCroix v. Commissioner, 61 T.C. 471(phrase “tangible personal property” interpreted for
purposes of sec. 179).
The same point, that differences in statutory terminology
ordinarily lead to the conclusion of differences in meaning, is
also made in Berry Petroleum Co. & Subs. v. Commissioner, 104
T.C. 584, 646 n.41 (1995), affd. without published opinion 142
F.3d 442 (9th Cir. 1998). See supra note 9.
- 51 -
historical development increases the likelihood that the Congress
was actually aware that “active conduct of a trade or business”
figured in both the WHTC provisions and in section 936.
In light of the foregoing, we reject respondent’s contention
that WHTC cases “are not applicable to a section 936 issue”, and
we conclude that respondent’s citation of Norfolk S. Corp. v.
Commissioner, supra, does not provide any support for
respondent’s contention. On the contrary, we regard WHTC
opinions as authority with respect to the meaning of identical
language in section 936.
ii. Expressio Unius * * *
Respondent contends as follows:
“There is a venerable rule of statutory construction
which states: expressio unius est exclusio alterius (the
expression of one thing implies the exclusion of another
thing).” Section 936(a)(2)(B) does not refer to attribution
of activities, such as contract manufacturing; however,
section 936(h)(5)(B)(iii)(II) does refer to “contract
manufacturing.” “Where Congress includes particular
language in one section of a statute but omits it in another
section of the same [statute], it is generally presumed that
Congress acts intentionally and purposely in the disparate
inclusion or exclusion.”
In choosing the words “such domestic corporation” as
the statutory standard in section 936(a)(2)(B), without
reference to attribution of another’s activities, such as
the activities of a contract manufacturer, Congress limited
consideration exclusively to the domestic corporation’s
conduct in the possession. In other words, the activities
of others cannot be attributed to the domestic corporation
for purposes of section 936(a)(2)(B). [Citations omitted.]
In effect, the “expressio unius” rule to which respondent
draws our attention is merely the obverse of what we have
- 52 -
discussed supra note 9 and accompanying text. Ordinarily, in
statutes and other legal documents, it is presumed that if the
drafter uses the same terminology in several places then the
drafter intends the same meaning in each such place. By the same
token it is presumed that if the drafter varies the terminology
then the drafter intends that the meaning also varies. Or, as
Dickerson put it in the Interpretation and Application of
Statutes 224 (1975), it is presumed that the drafter “has
committed neither ‘elegant variation’ nor ‘utraquistic
subterfuge’.”
A problem with the “expressio unius” rule is that, although
the rule tells us that a different meaning is probably intended,
it often is difficult to determine what that different meaning
is. See, e.g., Black’s Law Dictionary 602 (7th ed. 1999). The
instant cases illustrate how the party that invokes this rule can
find that the rule favors the other side. See, e.g., Ginsburg,
“Making Tax Law Through the Judicial Process,” 70 A.B.A.J. 74, 76
(1984).
In general, section 936(h) deals with the treatment of
intangible property income. It provides that the domestic
shareholders of a qualified domestic corporation which elects the
possession tax credit are required to include in their gross
income as of the close of the electing corporation’s tax year
their pro rata share of the possessions corporation’s intangible
- 53 -
property income as United States source income unless an election
out is made by the possessions corporation. Sec. 936(h)(1)(A).
However, the general rule of possessions corporations is
inapplicable if an eligible possessions corporation elects out of
its provisions by electing to use either the cost sharing method
or the profit split method for computing its taxable income.
This election may be made under section 936(h)(5). For purposes
of subparagraph (B) of section 936(h)(5), costs incurred by the
electing corporation or a member of its affiliated group in
connection with contract manufacturing by a person other than a
member of the affiliated group are not treated as production
costs of the electing corporation in the possession or as direct
material costs or as compensation for services performed in the
possession. Sec. 936(h)(5)(B)(iii)(II). Rather, they are
treated as the direct labor costs of the affiliated group. Id.
The effect of the term “contract manufacturing” in section
936(h)(5)(B)(iii)(II) is to make it more difficult to establish a
substantial business presence in a possession--within the meaning
of section 936(h)(5)(B)(i)--when the possessions corporation uses
contract manufacturing for its manufacturing activities. The
term appears in a rule which is statutorily directed to apply
“For purposes of this subparagraph,” that is, subparagraph (B) of
section 936(h)(5). Thus, when examined in context, the
“expressio unius” canon of construction suggests that contract
- 54 -
manufacturing is to be given a special unfavorable (for the
taxpayer) effect only for purposes of section 936(h)(5)(B), and
that for all other section 936 purposes contract manufacturing is
not to be given an effect unfavorable to the taxpayer. It
follows that the canon of construction that respondent urges upon
us does not lead to the result for which respondent contends, but
rather (when the context is considered) it supports the result
for which petitioners contend.
iii. Plain Meaning; Legislative History
Respondent contends that the plain meaning of “such domestic
corporation” in the statute, and the plain meaning of “it” and
“its gross income” in the report of the Senate Finance Committee,
lead to the conclusion that “only the possessions corporation’s
conduct can be considered for purposes of satisfying the active
business requirement.”
The same statutory language has been in the predecessors of
section 936 since the initial enactment--section 262 of the
Revenue Act of 1921, Pub. L. 67-98, 42 Stat. 227, 271. The same
statutory language was in the WHTC provisions--sec. 109, I.R.C.
1939. Essentially the same argument was presented to, and
rejected by, the Court of Appeals for the Ninth Circuit in Frank
v. International Canadian Corp., 308 F.2d at 526-527. In our
recent opinion in MedChem (P.R.), Inc. v. Commissioner, 116 T.C.
- 55 -
at 337, we interpreted the statute to allow attribution of the
services of nonemployees if certain conditions are satisfied.
Thus, the courts have interpreted this language to not
preclude attribution as a matter of law, but rather as permitting
attribution or not depending on the factual setting. A careful
examination of respondent’s contention that the plain meaning of
the statute and its legislative history precludes attribution
leads us to conclude that such a plain meaning cannot be drawn
from the statute and its legislative history.
5. Holding
We conclude that EAPR’s manufacturing arrangement in Puerto
Rico met the requirements of the section 936 active-conduct-of-a
-trade-or-business test as we interpreted it in MedChem. This is
a highly factual determination. Frank is also persuasive in this
context.
Further, we conclude that petitioners have met their burden
of showing that there is not any genuine issue as to any material
fact with respect to whether EAPR actively conducted a trade or
business in Puerto Rico within the meaning of section
936(a)(2)(B).
Accordingly, we hold that petitioners are entitled to
summary judgment on this issue.
- 56 -
C. Significant Business Presence
1. The Statutory Setting of the Dispute
If a possessions corporation has “intangible property
income”, then that income is generally treated as income of the
possessions corporation’s shareholders, in accordance with rules
set forth in section 936(h). However, a possessions corporation
may “elect out” under section 936(h)(5)12 and choose to compute
12
Par. (5) of sec. 936(h) provides, in pertinent part, as
follows:
(5) Election Out.–-
(A) In general.--The rules contained in
paragraphs (1) through (4) do not apply for any
taxable year if an election pursuant to
subparagraph (F) is in effect to use one of the
methods specified in subparagraph (C).
(B) Eligibility.--
(i) Requirement of significant business
presence.–-An election may be made to use one
of the methods specified in subparagraph (C)
with respect to a product or type of service
only if an electing corporation has a
significant business presence in a possession
with respect to such product or type of
service. An election may remain in effect
with respect to such product or type of
service for any subsequent taxable year only
if such electing corporation maintains a
significant business presence in a possession
with respect to such product or type of
service in such subsequent taxable year. If
an election is not in effect for a taxable
year because of the preceding sentence, the
electing corporation shall be deemed to have
revoked the election on the first day of such
taxable year.
(continued...)
- 57 -
12
(...continued)
(ii) Definition.--For purposes of this
subparagraph, an electing corporation has a
“significant business presence” in a
possession for a taxable year with respect to
a product or type of service if:
(I) the total production costs
(other than direct material costs and
other than interest excluded by
regulations prescribed by the Secretary)
incurred by the electing corporation in
the possession in producing units of
that product sold or otherwise disposed
of during the taxable year by the
affiliated group to persons who are not
members of the affiliated group are not
less than 25 percent of the difference
between (a) the gross receipts from
sales or other dispositions during the
taxable year by the affiliated group to
persons who are not members of the
affiliated group of such units of the
product produced, in whole or in part,
by the electing corporation in the
possession, and (b) the direct material
costs of the purchase of materials for
such units of that product by all
members of the affiliated group from
persons who are not members of the
affiliated group; or
(II) no less than 65 percent of the
direct labor costs of the affiliated
group for units of the product produced
during the taxable year in whole or in
part by the electing corporation or for
the type of service rendered by the
electing corporation during the taxable
year, is incurred by the electing
corporation and is compensation for
services performed in the possession; or
(III) with respect to purchases and
sales by an electing corporation of all
(continued...)
- 58 -
its relevant taxable income under one of the methods described in
section 936(h)(5)(C)--the cost sharing method or the profit split
method--but only if the possessions corporation “has a
significant business presence” in a possession. Sec.
936(h)(5)(B)(i). Section 936(h)(5)(B)(ii) provides that a
possessions corporation “has a ‘significant business presence’”
in a possession if the corporation satisfies any one of three
statutory tests. These three tests are (1) the 25-percent-value
-added test, (2) the direct-labor-production test, and (3) the
12
(...continued)
goods not produced in whole or in part
by any member of the affiliated group
and sold by the electing corporation to
persons other than members of the
affiliated group, no less than 65
percent of the total direct labor costs
of the affiliated group in connection
with all purchases and sales of such
goods sold during the taxable year by
such electing corporation is incurred by
such electing corporation and is
compensation for services performed in
the possession.
Notwithstanding satisfaction of one of the
foregoing tests, an electing corporation
shall not be treated as having a significant
business presence in a possession with
respect to a product produced in whole or in
part by the electing corporation in the
possession, for purposes of an election to
use the method specified in subparagraph
(C)(ii), [the profit split method] unless
such product is manufactured or produced in
the possession by the electing corporation
within the meaning of subsection (d)(1)(A) of
section 954.
- 59 -
direct-labor test for purchases and resales, set forth in
subclauses (I), (II), and (III), respectively, of section
936(h)(5)(B)(ii). However, the final flush language of section
936(h)(5)(B)(ii) provides that, if the possessions corporation
claims the profit split method with respect to a product that the
possessions corporation produces in whole or in part in the
possession, then the possessions corporation does not have a
significant business presence in that possession--
unless such product is manufactured or produced in the
possession by the electing corporation within the
meaning of subsection (d)(1)(A) of section 954.
Respondent refers to the alternative tests set out in the
three subclauses of section 936(h)(5)(B)(ii) as “the first
prong”, and refers to the test set out in the final flush
language of section 936(h)(5)(B)(ii) as “the second prong”. That
terminology appears to be helpful, and we use it in the instant
opinion.
2. Parties’ Contentions
Many of the parties’ contentions on this issue are similar
to those that they made with respect to the active-conduct-of-a-
trade-or-business issue. In particular, respondent contends that
petitioners’ partial summary judgment motion must be denied
because (1) “as a matter of law * * * Petitioners cannot
attribute the activities of the PPI [employees] or EA employees
to EAPR” to satisfy the significant-business-presence test under
- 60 -
section 936(h)(5)(B), and (2) if attribution is not per se
impermissible, then “there are material facts in dispute that are
relevant to the statutory” test. As to attribution, respondent
contends that (a) it is contrary to the plain meaning of the
statutory text; (b) it violates the “firmly established rule of
statutory construction that states: expressio unius est exclusio
alterius (the expression of one thing implies the exclusion of
another thing)”; (c) the legislative history shows that the
Congress did not intend to permit attribution to satisfy the
profit split method; and (d) absent attribution, EAPR’s own
activities do not constitute the manufacture or production of the
video games.
Respondent urges that the “Congress did not intend its
reference [in sec. 936(h)(5)(B)(ii) (final flush)] to section
954(d)(1) to lessen the requirement that the corporation electing
the profit split method must manufacture the product”, without
“taking into account the activities of a contract manufacturer.”
Also, respondent contends, the Court should not take into account
respondent’s interpretation of section 954 in Rev. Rul. 75-7,
1975-1 C.B. 244.13 Respondent contends that, if attribution is
13
Interestingly, respondent includes the following among the
reasons why we should not rely on Rev. Rul. 75-7, 1975-2 C.B.
244, even though that ruling was extant when sec. 936(h) was
enacted:
In Ashland Oil, [95 T.C. 348 (1990)], the court stated:
(continued...)
- 61 -
not prohibited as a matter of law, then there are the following
genuine issues of material fact: (a) Whether the video games
were manufactured in Puerto Rico or in the Dominican Republic;
and (b) “exactly what level of involvement in Puerto Rico EAPR
had in the manufacturing process * * * and whether that level of
manufacturing activity is significant enough to permit the
attribution of the activities of the PPI employees to EAPR for
purposes of the significant business presence test.”
Petitioners contend that EAPR satisfied the first prong of
the significant business presence test by satisfying the direct
labor test of section 936(h)(5)(B)(iii)(II). Petitioners contend
that EAPR satisfied the second prong of the significant business
presence test, and thus is eligible to use the profit split
method, because EAPR met all the manufacturing requirements of
section 1.954-3(a)(4), Income Tax Regs. Petitioners maintain
that PPI was not the manufacturer within the meaning of the cited
regulation. Petitioners also rely on the inventory provisions
(sections 471 and 263A, and the regulations thereunder, and Rev.
13
(...continued)
“Revenue rulings represent only the Commissioner’s
position concerning specific factual situations, rather
than substantive authority for deciding a case in this
court.” Id. at 360. Other courts have similarly held
that revenue rulings are not binding on the
Commissioner, the Secretary or the courts. Schuster v.
Commissioner, 800 F.2d 627 (7th Cir. 1986), aff’g 84
T.C. 764 (1985), citing Dickman v. Commissioner, 465
U.S. 330 (1984); Stubbs, Overbeck & Associates v.
United States, 445 F.2d 1142 (5th Cir. 1971).
- 62 -
Rul. 81-272, 1981-2 C.B. 116) and on Rev. Rul. 75-7, 1975-2 C.B.
244, to show that EAPR was the manufacturer. Petitioners contend
that what EAPR did satisfied the congressional purpose of
creating jobs in Puerto Rico.
In response to respondent’s “expressio unius” contentions,
petitioners maintain that the Congress’s inclusion of “contract
manufacturing” as a consideration in section
936(h)(5)(B)(iii)(II) that limits the ability of a corporation to
qualify for significant business presence treatment, should
properly lead to a conclusion that contract manufacturing does
not otherwise limit the ability of a corporation to so qualify.
In response to respondent’s contention that the video games,
or some of them, were manufactured in the Dominican Republic,
petitioners rely on the stipulation that the video games were
manufactured in Puerto Rico.
On opening brief, petitioners state that EAPR satisfied the
first prong “and Respondent does not contend otherwise.”
Respondent states that “Respondent did not contend otherwise,
however, until having obtained the unsigned Declaration of Miguel
Orlando Alvarado.” The only objection that respondent then
states as to the first prong is that “it is highly likely that
some of the direct labor costs claimed by Petitioners to have
been expended in the possession were really expended in the
Dominican Republic.”
- 63 -
3. Summary of Conclusions
As we have stated supra (B.4.a.i. Place of Manufacture), we
view the parties’ stipulations differently than respondent. In
the relevant stipulations--executed and filed 9 days after
respondent completed the Alvarado Declaration that respondent
submitted in opposition to petitioners’ summary judgment motion--
the parties have agreed that “the video games at issue” were
manufactured in Puerto Rico. This precludes respondent from
contending that, to some extent, the video games that are
relevant in the instant cases were manufactured in the Dominican
Republic or any place else other than Puerto Rico. Thus, the
only predicate of respondent’s only challenge to EAPR’s
satisfaction of the first prong drops out, and petitioners are
entitled to partial summary judgment that EAPR satisfied the
first prong.
This leaves the second prong as the only bone of contention
on this issue, whether EAPR satisfies the requirement that the
video games were “manufactured or produced” in Puerto Rico “by”
EAPR “within the meaning of subsection (d)(1)(A) of section 954.”
Our examination of (1) section 936(h)(5)(B)(ii) and the
legislative history of that provision’s enactment in 1982, and
(2) section 954(d)(1)(A) and the legislative history of that
provision’s enactment in 1962, convinces us that there is not an
absolute requirement that only the activities actually performed
- 64 -
by a corporation’s employees or officers are to be taken into
account in determining whether the corporation manufactured or
produced a product in a possession, within the meaning of
sections 936(h)(5)(B)(ii) (final flush) and 954(d)(1)(A).
By the same token, petitioners’ focus on certain language in
section 1.954-3(a)(4), Income Tax Regs., overlooks the
regulation’s requirement that various actions have been done “by”
the corporation being evaluated. Also, because of our evaluation
in Spalding v. Commissioner, 66 T.C. 1017 (1976), we conclude
that the Code’s inventory provisions that petitioners rely on are
not good precedents for interpreting “manufactured or produced”
within the meaning of section 954(d)(1)(A).
In light of our rejection of both sides’ views of the law,
we conclude that proper evaluation of the merits of the instant
cases requires a fuller development of the facts and perhaps a
fuller exposition of the law consistent with the views we have
expressed in this opinion. Under these circumstances, we
conclude that petitioners have failed to carry their burden of
proving that they are entitled to summary judgment as to the
second prong.
4. Analysis
The dispute as to the second prong centers on the meaning of
the final flush language of section 936(h)(5)(B)(ii), requiring
that the product have been--
- 65 -
(a) manufactured,
(b) in Puerto Rico,
(c) by EAPR,
and that this have been done “within the meaning of subsection
(d)(1)(A) of section 954.”
Ordinarily, if we do not have a clear authoritative
interpretation of this language in section 936(h)(5)(B)(ii)
(final flush), then we would examine other Code provisions that
use the same language and treat interpretations of any such Code
provisions as authoritative, or at least highly persuasive,
definitions of this language. See, e.g., supra note 9 and
accompanying text, and our analysis of the meaning of “active
conduct of a trade or business”. However, we have held that the
terms “manufactured” and “produced” are not to be so analyzed.
In Spalding v. Commissioner, 66 T.C. 1017 (1976), the
taxpayers constructed an 8-foot chain link fence around that
portion of their auto wrecking yard in which their employees
dismantled autos and stored salvaged parts. Id. at 1019. The
issue before us was whether this fence qualified for the
investment credit. Id. In order to resolve this issue we had to
decide whether the taxpayers’ activity constituted
“manufacturing” or “production” within the meaning of section
48(a)(1)(B)(i), I.R.C. 1954. We opined that the taxpayers’
activity apparently would not constitute manufacturing or
production under section 954(d)(1)(A) but would under section
- 66 -
341. 66 T.C. at 1020-1021. We concluded as follows, id. at
1021:
Therefore we conclude that “manufacturing” and
“production” have no uniform generalized meaning in the
Code and we must look to the purposes and legislative
history of section 48 for their specific meaning here.
To the same effect, see Garnac Grain Co. v. Commissioner, 95 T.C.
7, 30-31 (1990).
As best we can tell, we are most likely to give the same term
different meanings in different places (i.e., to conclude that the
drafter committed a “utraquistic subterfuge”, whether intentionally
or by mistake) if the term is short (e.g., the one-word terms
“manufacturing” and “production”) and is used in common (i.e.,
nonlegal) speech with a variety of meanings. In any event, it is
clear that, as to “manufactured” and “produced”, we must focus on
the sections directly before us, and we are not likely to draw much
assistance from the interpretation of those words as they appear in
other statutes. However, see discussion infra (a. Legislative
History--Sec. 936(h)), where a portion of the 1982 Act explanation
by the conference committee states as follows:
In general, the figures to be used for these calculations [the
first prong tests] will be those used by the island affiliate
and its affiliates in their required inventory calculations.
[H. Conf. Rept. 97-760, 506, 1982-2 C.B. 600, 619.]
On this issue, also, respondent makes the “expressio unius”
contention that the reference to “contract manufacturing” in
section 936(h)(5)(B)(iii)(II), and the treatment of that subject
in section 1.936-5(c), Q&A-3, Income Tax Regs., mean that
- 67 -
contract manufacturing is not to be taken into account for any
other purposes, including specifically the analysis of whether
the possessions corporation is the manufacturer for purposes of
our second prong analysis. Respondent takes the position that
both the cited statute and the cited regulation apply only to the
first prong.
On the basis of the analysis set forth supra (B.4.b.ii),
relating to the “active conduct of a trade or business” issue, we
conclude that respondent’s contention favors petitioners to some
extent. That is, the presence of a restriction on contract
manufacturing when evaluating the first prong, and the absence of
that term in the second prong, may mean that contract
manufacturing is not restricted under the second prong.
Neither side has drawn our attention to, and we have not
found, caselaw interpreting the provisions of either section
936(h)(5)(B)(ii) or section 954(d)(1)(A) as relevant to the
instant cases.14 Accordingly, we examine the origins of these
14
See, e.g., Vetco, Inc. v. Commissioner, 95 T.C. 579, 594
(1990), in which we ruled that we would “not address whether
* * * [the subsidiary corporation] was engaged in manufacturing”,
because our determination under sec. 954(d)(2) made it
unnecessary to answer the manufacturing question. See also id.
at 580.
In Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C.
338 (1972), we held that activities of a subsidiary of the
taxpayer amounted to manufacturing within the meaning of sec.
954(d)(1)(A). In Webb Export Co. v. Commissioner, 91 T.C. 131(1988), we concluded that activities of a taxpayer amounted to
production within the meaning of sec. 954(d)(1)(A), and we held
(continued...)
- 68 -
provisions in order to determine whether we can conclude that
petitioners are entitled to summary judgment on the matter before
us.
a. Legislative History--Sec. 936(h)
Subsection (h) was added to section 936 by section 213(a)(2)
of the Tax Equity and Fiscal Responsibility Act of 1982
(hereinafter sometimes referred to as TEFRA 82), Pub. L. 97-248,
96 Stat. 324, 452. The bill (H.R. 4961) as passed by the House
of Representatives did not have a provision corresponding to
subsection (h). H. Conf. Rept. 97-760, at 504 (1982), 1982-2
14
(...continued)
as a result that these activities amounted to production within
the meaning of sec. 993(c)(1)(A). In each of these cases it
appears that all the relevant work was done directly by employees
of the company whose qualifications were in dispute. The
question before the Court in each of those cases was whether
there was manufacturing or producing. In the instant cases,
respondent states on answering brief: “Respondent does not
dispute that there was manufacturing. The issue is, rather, who
did the manufacturing.” We do not believe that either Dave
Fischbein Manufacturing Co. or Webb Export Co. is helpful in
deciding whether EAPR manufactured or produced the video games
here in dispute; neither side cites either of those opinions.
Both sides cite Bausch & Lomb, Inc. v. Commissioner, T.C. Memo.
1996-57. We conclude that that opinion is not helpful in
resolving the issue presented in the instant cases for the same
reason that Dave Fischbein Manufacturing Co. and Webb Export Co.
are not helpful--they focus on whether there was manufacturing or
production, not on whether the subject corporation could properly
be considered to be responsible for the manufacturing or
production.
A recent review of some of the materials in this area does
not deal with the significance of (1) variations in statutory
language and (2) the analysis in Spalding v. Commissioner, 66
T.C. 1017 (1976). Levine et al., “Assessing the Manufacturing
Exception to Subpart F Through Contract Manufacturing
Arrangements”, 1 Taxation of Global Transactions 37 (2001).
- 69 -
C.B. 600, 617; see also Staff of Joint Comm. on Taxation, General
Explanation of the Revenue Provisions of the Tax Equity And
Fiscal Responsibility Act of 1982, 79 n.* (J. Comm. Print 1982)
(hereinafter sometimes referred to as JCT Staff General
Explanation). The bill as reported by the Senate Finance
Committee and as passed by the Senate included subsection (h), as
proposed to be enacted by section 218(a)(2) of the bill, but did
not have a provision corresponding to paragraph (5)--the
election-out provision. See text of H.R. 4691 reported by the
Senate Finance Committee, 258-266; text of the Senate-passed
amendments, 263-271. The election-out provision was added in
conference, and was described in pertinent part as follows in the
Joint Statement of Managers portion of the conference committee
report (H. Conf. Rept. 97-760, 505, 510, 1982-2 C.B. at 617-618,
620; see also JCT Staff General Explanation 85, 87, 92):
Intangible income
An election may be made to treat income
attributable to certain intangible property as income
of the section 936 corporation eligible for the credit
(and certain domestic corporations operating in the
Virgin Islands) under two options--(1) a cost sharing
rule and (2) a 50/50 profit split. The two exceptions
with respect to certain types of intangible property
found in the Senate amendment are deleted. In
addition, an exception to the Senate bill is made for
intangible property which has been licensed since prior
to 1948 to a U.S. corporation operating in a possession
and is in use by such corporation on the date of
enactment.
* * * * * * *
- 70 -
50/50 split of combined taxable income
In general
This election will provide for a split between the
island affiliate and its U.S. affiliates of the
combined taxable income of the island affiliate and its
U.S. affiliates with respect to products produced, in
whole or in part, in the possession. 50% of such
profit will be allocated to the island affiliate; 50%
will be allocated to its U.S. affiliates.
Significant business presence
For an island affiliate to be eligible to apply
the profit split, it must satisfy one of the
significant business presence tests required for the
cost sharing election for the product or type of
service covered by the election. [The first prong.]
In addition, for products produced in whole or part by
the island affiliate in the possession, the profit
split method is available only if the island affiliate
manufactures or produces the product in the possession
within the meaning of the controlled foreign
corporation provisions of the Code (section 954). [The
second prong.] If the significant business presence
test (including the controlled foreign corporation
manufacturing or production rule) is not satisfied for
a product or type of service within the product area
covered by the election, no intangibles income
attributable to that product or type of service will be
eligible for the credit.
Respondent’s brief draws our attention to two passages in
the Joint Statement of Managers portion of the conference
committee report, as follows:
Congressional concerns regarding the potential adverse
effects of the possessions credit on revenues is reflected
in the conference report for section 936(h):
The provision as modified is intended to lessen
the abuse caused by taxpayers claiming tax-free
income generated by intangibles developed outside
of Puerto Rico. The conferees also intend that
the provision be administered in a fashion so as
to encourage increased Puerto Rican employment and
- 71 -
investment in depreciable property at as low a
cost to the Treasury as possible. [Quoting H.
Conf. Rept. 97-760, at 505 (1982), 1982-2 C.B.
600, 617.]
* * * * * * *
To meet its concerns, Congress incorporated a
requirement for “real” investment into subsection (h). At
this point, Congress inserted the requirement at issue that
in order for a possessions corporation to be eligible to
elect one of the favorable income allocation methods when
intangibles were involved, the corporation had to meet the
significant business presence test. The activities
necessary to meet this test were to prompt “real and
significant business activity” [id. at 507, supra, 1982-2
C.B. at 618-619] in the possessions.
The quoted items appear in the conference committee report; the
quoted language “real and significant business activity” is part
of the following explanation by the conference committee:
Significant business presence
For an island affiliate to be eligible to elect cost
sharing for a product or type of service, it must have and
maintain a significant business presence in the possession
with respect to that product or type of service. This test
is intended to require real and significant business
activity in the possessions.
The island affiliate satisfies this requirement with
respect to a product or type of service if (1) more than 25
percent of the value added by the affiliated group to the
product is added by the island affiliate in a possession or
(2) at least 65 percent of the direct labor costs of the
affiliated group for the product or service (or in
connection with the purchase and sale of goods not produced
by the affiliated group) are incurred by the island
affiliate and are compensation for services rendered in the
possession. In general, the figures to be used for these
calculations will be those used by the island affiliate and
its affiliates in their required inventory calculations.
The Secretary may prescribe regulations providing
- 72 -
significant business presence tests for other appropriate
cases (including a value added test for services), which are
consistent with the statutory tests.
Id. at 507, supra, 1982-2 C.B. 618-619.
We are at a loss to understand how the foregoing advances
the thesis of that part of respondent’s brief, that “Attribution
is contrary to the legislative history and the purpose behind the
enactment of section 936.”
Respondent’s focus on “cost to the Treasury” led us to
examine the revenue estimates for the “Limit on possession
credit” provisions, as they appeared in the Senate Finance
Committee report (S. Rept. 97-494 Vol. 1, 102-103 (1982)), and
the conference committee report (H. Conf. Rept. 97-760, 692-693
(1982)), which are set forth in table 4.15
Table 4
Estimated increase in revenue
(millions of dollars) from:
Fiscal Senate Finance Conference
Year Committee amendment agreement
1983 412 201
1984 1,027 428
1985 1,251 473
1986 1,356 516
1987 1,470 559
The conference committee added paragraph (5), the election-
out provision we deal with in the instant cases, to the Senate
15
For a recent example of the use of congressional numerical
estimates as an aid in interpreting legislation, see Toyota Motor
Mfg., Kentucky, Inc. v. Williams, 534 U.S. 184, ___ (2002) (slip
op. at 9).
- 73 -
amendment’s new section 936(h), and also modified other parts of
the Senate amendment. We cannot tell from the public record how
much of the substantial “cost to the Treasury” (i.e., reduction
in the estimated amount of the revenue increase) is attributable
to the election-out change and how much is attributable to the
other changes. Nevertheless, it is clear that the Congress was
willing to forgo substantial revenue (estimated at almost a
billion dollars for fiscal 1987 alone) as a result of the
determination to modify the provisions of the Senate Amendment.
Under these circumstances, we have no way of knowing (or even
making an educated guess) as to whether the “cost to the
Treasury” phrase in the Joint Statement of Managers was intended
to refer to the election-out provision or any specific other
provision in the revisions relating to the possessions credit.
Respondent’s other legislative history focus--the statement
that the significant-business-presence test “is intended to
require real and significant business activity in the
possessions”--is in that part of the conference committee’s
explanatory statement that deals with “significant business
presence” for purposes of the cost sharing election--what we have
referred to as the first prong. As we have pointed out, supra,
respondent has already stipulated away the only challenge that
respondent makes on brief as to whether EAPR has satisfied the
first prong. Thus, to the extent that the conference committee’s
- 74 -
explanatory statement is helpful in explaining the test of the
first prong, in the instant cases EAPR has met that test.
We conclude that respondent’s legislative history analysis
does not add even a makeweight to respondent’s view of the law.
However, the legislative history (in this instance,
primarily the sequence of events) does tell us something. The
Senate amendment does not refer to section 954 in its version of
proposed section 936(h). The Conference Committee added
paragraph (5) to section 936(h), and specifically made
satisfaction of the second prong depend on “the meaning of
subsection (d)(1)(A) of section 954.”
As a result, in order to understand how to apply the second
prong, we must examine subsection (d)(1)(A) of section 954.
b. Legislative History--Sec. 954(d)
Enacted by the Revenue Act of 1962, section 954(d) is part
of subpart F of part III of subchapter N of chapter 1. Through
subpart F, the Congress sought to limit the tax-deferral
abilities of certain foreign corporations--those meeting the
definition of a “controlled foreign corporation”. Vetco, Inc. v.
Commissioner, 95 T.C. 579, 585-586 (1990). Under subpart F
(secs. 951 through 964), a U.S. shareholder of a “controlled
foreign corporation” generally must include in gross income a pro
rata share of the corporation’s foreign base company income,
- 75 -
which includes, inter alia, foreign base company sales income.
Section 954(d)(1) provides, in pertinent part, as follows:
SEC. 954. FOREIGN BASE COMPANY INCOME.
(d) Foreign Base Company Sales Income.--
(1) In general.--For purposes of subsection
(a)(2), the term “foreign base company sales income”
means income (whether in the form of profits,
commissions, fees, or otherwise) derived in connection
with the purchase of personal property from a related
person and its sale to any person, the sale of personal
property to any person on behalf of a related person,
the purchase of personal property from any person and
its sale to a related person, or the purchase of
personal property from any person on behalf of a
related person where--
(A) the property which is purchased (or in
the case of property sold on behalf of a related
person, the property which is sold) is
manufactured, produced, grown, or extracted
outside the country under the laws of which the
controlled foreign corporation is created or
organized, and
* * * * * * *
For purposes of this subsection, personal property does
not include agricultural commodities which are not
grown in the United States in commercially marketable
quantities.
The language of section 954(d)(1)(A) appeared in almost
identical form as proposed new Code section 952(e)(2)(A) in H.R.
10650 (bill pp. 112-113), the Revenue Act of 1962, as reported by
the House Ways and Means Committee. The enacted language
appeared in identical form as proposed new Code section
954(d)(1)(A) in H.R. 10650 (bill p. 190), as reported by the
Senate Finance Committee. H. Conf. Rept. 87-2508 (1962), 6-7
- 76 -
(statutory language), 31 (description), 1962-3 C.B. 1129, 1159.
The committee reports explain as follows:
The “foreign base company sales income” referred to
here means income from the purchase and sale of property,
without any appreciable value being added to the product by
the selling corporation. This does not, for example,
include cases where any significant amount of manufacturing,
major assembling, or construction activity is carried on
with respect to the product by the selling corporation. On
the other hand, activity such as minor assembling,
packaging, repackaging or labeling will not be sufficient to
exclude the profits from this definition.
The sales income with which your committee is primarily
concerned is income of a selling subsidiary (whether acting
as principal or agent) which has been separated from
manufacturing activities of a related corporation merely to
obtain a lower rate of tax for the sales income. This
accounts for the fact that this provision is restricted to
sales of property, to a related person, or to purchases of
property from a related person. Moreover, the fact that a
lower rate for tax for such a company is likely to be
obtained only through purchases and sales outside of the
country in which it is incorporated, accounts for the fact
that the provision is made inapplicable to the extent the
property is manufactured, produced, grown, or extracted in
the country where the corporation is organized or where it
is sold for use, consumption, or disposition in that
country. Mere passage of title or the place of the sale are
not relevant in this connection.
* * * * * * *
(d) Foreign base company sales income.--Paragraph (1)
of subsection (d) corresponds to section 952(e)(2) of the
bill as passed by the House and defines foreign base company
sales income as income (whether in the form of profits,
commissions, fees, or otherwise) derived in connection with:
(1) the purchase of personal property from a
related person and its sale to any person,
(2) the sale of personal property to any person on
behalf of a related person,
- 77 -
(3) the purchase of personal property from any
person and its sale to a related person, or
(4) the purchase of personal property from any
person on behalf of a related person,
where (A) the property which is purchased (or in the case of
property sold on behalf of a related person, the property
which is sold) is manufactured, produced, grown, or
extracted outside the country under the laws of which the
controlled foreign corporation is created or organized, and
(B) the property is sold for use, consumption, or
disposition outside such foreign country, or, in the case of
property purchased on behalf of a related person, is
purchased for use, consumption, or disposition outside such
foreign country.
The definition does not apply to income of a controlled
foreign corporation from the sale of a product which it
manufactures. In a case in which a controlled foreign
corporation purchases parts or materials which it then
transforms or incorporates into a final product, income from
the sale of the final product would not be foreign base
company sales income if the corporation substantially
transforms the parts or materials, so that, in effect, the
final product is not the property purchased. Manufacturing
and construction activities (and production, processing, or
assembling activities which are substantial in nature) would
generally involve substantial transformation of purchased
parts or materials. [S.Rept. 87-1881, 84, 245 (1962), 1962-
3 C.B. 703, 790, 949; H. Rept. 87-1447, 62, A94-A95 (1962),
1962-3 C.B. 402, 466, 592-593.]
In general, taxpayers found it beneficial under subpart F to
show that income of a controlled foreign corporation was derived
from the sale of personal property which was manufactured or
produced in a foreign country by the controlled foreign
corporation.
c. Harmonizing; Conclusions
In the instant cases each side contends that Treasury
Regulations require a decision favoring that side. Respondent
- 78 -
urges us to rely on section 1.936-5(b)(6), Q&A-1, Income Tax
Regs.16 Petitioners urge us to rely on section 1.954-3(a)(4),
16
Sec. 1.936-5(b)(6), Q&A-1, Income Tax Regs., provides as
follows:
Sec. 1.936-5 Intangible property income when an election
out is made: Product, business presence, and contract
manufacturing.
* * * * * * *
(b) Requirement of significant business presence--
* * * * * * *
(6) Manufacturing within the meaning of section
954(d)(1)(A).
Q. 1: What is the test for determining, within the
meaning of section 954(d)(1)(A), whether a product is
manufactured or produced by a possessions corporation in a
possession?
A. 1: A product is considered to have been
manufactured or produced by a possessions corporation in a
possession within the meaning of section 954(d)(1)(A) and
sec. 1.954-3(a)(4) if--
(i) The property has been substantially transformed
by the possessions corporation in the possession;
(ii) The operations conducted by the possessions
corporation in the possession in connection with the
property are substantial in nature and are generally
considered to constitute the manufacture or production of
property; or
(iii) The conversion costs sustained by the possessions
corporation in the possession, including direct labor,
factory burden, testing of components before incorporation
into an end product and testing of the manufactured product
before sales account for 20 percent or more of the total
cost of goods sold of the possessions corporation.
In no event, however, will packaging, repackaging, labeling,
or minor assembly operations constitute manufacture or
production of property. See particularly examples 2 and 3
of sec. 1.954-3(a)(4)(iii).
- 79 -
Income Tax Regs.17 Respondent responds that--
17
Sec. 1.954-3(a)(4), Income Tax Regs., provides as follows
(examples omitted):
Sec. 1.954-3 Foreign base company sales income.
(a) Income included.
* * * * * * *
(4) Property manufactured or produced by the controlled
foreign corporation--(i) In general. Foreign base company
sales income does not include income of a controlled foreign
corporation derived in connection with the sale of personal
property manufactured, produced, or constructed by such
corporation in whole or in part from personal property which
it has purchased. A foreign corporation will be considered,
for purposes of this subparagraph, to have manufactured,
produced, or constructed personal property which it sells if
the property sold is in effect not the property which it
purchased. In the case of the manufacture, production, or
construction of personal property, the property sold will be
considered, for purposes of this subparagraph, as not being
the property which is purchased if the provisions of
subdivision (ii) or (iii) of this subparagraph are
satisfied. For rules of apportionment in determining
foreign base company sales income derived from the sale of
personal property purchased and used as a component part of
property which is not manufactured, produced, or
constructed, see subparagraph (5) of this paragraph.
(ii) Substantial transformation of property. If
purchased personal property is substantially transformed
prior to sale, the property sold will be treated as having
been manufactured, produced, or constructed by the selling
corporation. The application of this subdivision may be
illustrated by the following examples:
* * * * * * *
(iii) Manufacture of a product when purchased
components constitute part of the property sold. If
purchased property is used as a component part of personal
property which is sold, the sale of the property will be
treated as the sale of a manufactured product, rather than
the sale of component parts, if the operations conducted by
(continued...)
- 80 -
Petitioners’ primary authority should be the regulation that
explicates the section of the Internal Revenue Code that is
at issue in this case [i.e., sec. 936, which provides the
credit that is the subject of the dispute], particularly
where this regulation addresses the issue that is in
dispute.
Petitioners point out that the Congress made the choice of
requiring that the section 936(h)(5)(B)(ii) second prong test be
determined “within the meaning of section 954(d)(1)(A)”, and
“Accordingly, the determination of whether EAPR manufactured or
produced the video games must be made pursuant to section
954(d)(1)(A) (and the regulations and other authority
thereunder), and not pursuant to any other principles.”
Section 936(h)(5)(B)(ii) and the legislative history of its
enactment in TEFRA 82 make it clear that the test for satisfying
the second prong is to be that which is derived from section
954(d)(1)(A). In this, we agree with petitioners. We reject
17
(...continued)
the selling corporation in connection with the property
purchased and sold are substantial in nature and are
generally considered to constitute the manufacture,
production, or construction of property. Without limiting
this substantive test, which is dependent on the facts and
circumstances of each case, the operations of the selling
corporation in connection with the use of the purchased
property as a component part of the personal property which
is sold will be considered to constitute the manufacture of
a product if in connection with such property conversion
costs (direct labor and factory burden) of such corporation
account for 20 percent or more of the total cost of goods
sold. In no event, however, will packaging, repackaging,
labeling, or minor assembly operations constitute the
manufacture, production, or construction of property for
purposes of section 954(d)(1). * * *
- 81 -
respondent’s thesis, that regulations under section 936 must
control because the credit that petitioners claim is a credit
under section 936. However, we are not aware of, and petitioners
have not directed our attention to, any requirement that a
regulation cannot effectively control a determination under
section 954 unless it is a regulation under section 954. Section
7805(a), the basic regulation-prescribing authority for the
Treasury Department does not impose such a restriction.
Accordingly, we reject petitioners’ thesis, that we follow
regulations numbered 1.954 and ignore regulations numbered 1.936.
Instead, we conclude that both section 1.936-5(b)(6), Q&A-1,
Income Tax Regs., and section 1.954-3(a)(4), Income Tax Regs.,
are authoritative interpretations of the statute and guide us in
the instant cases in ruling on EAPR’s eligibility to use the
profit split method of section 936(h)(5)(C)(ii), by determining
whether or not the video games were manufactured or produced in
Puerto Rico by EAPR “within the meaning of (d)(1)(A) of section
954.” To the extent possible, we should harmonize the foregoing
regulations. See, e.g., Bencivenga v. Western Pa. Teamsters, 763
F.2d 574, 579 (3d Cir. 1985), where the Court of Appeals
“conclude[d] that in this instance the language of [Treasury]
Regulation 1.411(d)-3(b) is not in fact inconsistent with
Regulation 1.411(a)-7(a)(1)(ii).” We reach the same conclusion
with regard to the regulations before us.
- 82 -
Section 1.954-3(a)(4)(i), Income Tax Regs., provides the
following basic general rule:
Foreign base company sales income does not include
income of a controlled foreign corporation derived in
connection with the sale of personal property manufactured,
produced, or constructed by such corporation in whole or in
part from personal property which it has purchased.
[Emphasis added.]
The remaining language in subparagraph (4) expands on this basic
general rule. Petitioners’ focus on the text of these expansions
ignores the context provided by the general rule, that the
property must have been manufactured or produced by the
corporation that is the subject of the inquiry.
Section 1.936-5(b)(6), Q&A-1, Income Tax Regs., requires in
each of its alternatives, that the activity be performed “by the
possessions corporation”. Respondent’s focus on this phrase
ignores the fact that corporations pay persons (individuals or
other entities) to actually do things, and that the regulation
does not tell us whether we are to take into account for these
purposes only those things done by employees or officers of the
corporation that is the subject of the inquiry.
Neither of the foregoing regulations explicitly allows or
disallows “attribution”, even though both of these regulations
require that the corporation being tested be the manufacturer or
the producer. Thus, both regulations present the same question
of interpretation in almost the same words. In this respect, the
- 83 -
two regulations are consistent with each other, and neither
regulation clearly answers the question we face.
“Plain meaning” contentions notwithstanding, we cannot
properly lay the findings of fact next to the statute or
regulations and just read off the answers to the questions here
presented.18
Given that petitioners failed to consider the “by such
corporation” language of section 1.954-3(a)(4)(i), Income Tax
Regs., and that respondent failed to consider the reality that a
corporation engages others to do things on its behalf, we cannot
conclude with the requisite degree of certainty that the factual
record presented herein is sufficient. The shortcomings of the
parties’ legal contentions noted above make it far from clear
that all of the material facts have even been presented, let
alone that there is not a genuine issue with respect thereto.
Accordingly, even though we cannot agree with respondent’s
analysis, we conclude that petitioners have failed to carry their
obligation as movants to show that there is no substantial
18
See, e.g., the following description of a court’s role in
certain “simple” litigation:
When an act of Congress is appropriately challenged in the
courts as not conforming to the constitutional mandate the
judicial branch of the Government has only one duty,--to lay
the article of the Constitution which is invoked beside the
statute which is challenged and to decide whether the latter
squares with the former. * * * [United States v. Butler, 297
U.S. 1, 62 (1936).]
- 84 -
dispute about a material fact and that they are entitled to
judgment as a matter of law. See Anderson v. Liberty Lobby,
Inc., 477 U.S. 242, 255 (1986) (citing Kennedy v. Silas Mason
Co., 334 U.S. 249 (1948)).
5. Holding
We hold for respondent on the second prong--that
petitioners’ motion for partial summary judgment will not be
granted as to whether EAPR’s activities with respect to the video
games in the years before the Court amount to EAPR’s manufacture
or production of video games in Puerto Rico within the meaning of
subsection (d)(1)(A) of section 954. We hold for petitioners on
the first prong--that petitioners’ motion for partial summary
judgment will be granted as to whether EAPR’s activities with
respect to the video games in the years before the Court amount
to EAPR’s having a substantial business presence in Puerto Rico
within the meaning of clause (ii) of section 936(h)(5)(B) without
taking into account the requirements of the final flush language
of that clause.
An appropriate order will
be issued granting in part and
denying in part petitioners’
motion for partial summary
judgment.