[Federal Register Volume 65, Number 16 (Tuesday, January 25, 2000)]
[Rules and Regulations]
[Pages 3814-3817]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-1528]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8868]
RIN 1545-AV68


Termination of Puerto Rico and Possession Tax Credit; New Lines 
of Business Prohibited

AGENCY:  Internal Revenue Service (IRS), Treasury.

ACTION:  Final and Temporary regulations.

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SUMMARY:  This document amends the Income Tax Regulations by removing 
temporary regulations that provide guidance regarding the addition of a 
substantial new line of business by a possessions corporation that is 
an existing credit claimant and adding final regulations. These 
regulations are necessary to implement changes made by the Small 
Business Job Protection Act of 1996.

DATES:  Effective Date. These regulations are effective January 25, 
2000.

FOR FURTHER INFORMATION CONTACT:  Daniel S. Karen, (202) 874-1490, or 
Jacob Feldman, (202) 622-3830 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 1601(a) of the Small Business Job Protection Act of 1996, 
Public Law 104-188, 110 Stat. 1755 (1996), amended the Internal Revenue 
Code by adding section 936(j). Section 936(j) generally repeals the 
Puerto Rico and possession tax credit for taxable years beginning after 
December 31, 1995. However, the section provides grandfather rules 
under which a corporation that is an existing credit claimant would be 
eligible to claim credits for a transition period. The Puerto Rico and 
possession tax credit and the Puerto Rico economic activity credit 
phase out for these existing credit claimants ending with the last 
taxable year beginning before January 1, 2006.
    For taxable years beginning after December 31, 1995 and before 
January 1, 2006, the Puerto Rico and possession tax credit and the 
Puerto Rico economic activity credit apply only to a corporation that 
qualifies as an existing credit claimant (as defined in section 
936(j)(9)(A)). The determination of whether a corporation is an 
existing credit claimant is made separately for each possession. A 
possessions corporation that adds a substantial new line of business 
(other than in a qualifying acquisition of all the assets of a trade or 
business of an existing credit claimant) after October 13, 1995, ceases 
to be an existing credit claimant as of the beginning of the taxable 
year during which such new line of business is added. Therefore, a 
possessions corporation that ceases to be an existing credit claimant 
either because it has added a substantial new line of business, or 
because a new line of business becomes substantial, during a taxable 
year may not claim the Puerto Rico and possession tax credit or the 
Puerto Rico economic activity credit for that taxable year or any 
subsequent taxable year.
    On August 19, 1998, temporary regulations were published in the 
Federal Register (63 FR 44387). A cross referenced Notice of Proposed 
Rulemaking was also published in the Federal Register (63 FR 44416) on 
the same date. Three comments were received with respect to the Notice. 
No hearing was requested and none was held. The temporary regulations 
are, therefore, adopted as proposed with the following changes, as 
explained, below.

Explanation of Revisions and Summary of Comments

    Minor and conforming changes were made in these final regulations. 
Several changes were also made in the final regulations with regard to 
the three comments that were received on the Notice of Proposed 
Rulemaking.
    The first comment received addressed the issue as to whether the 
leasing of some of the assets of an existing credit claimant would 
result in a new line of business under section 936(j)(9)(B) with 
respect to the leasing activity. In response to the comment, the final 
regulations provide that the leasing out of assets by an existing 
credit claimant (and the employees necessary to operate the leased 
assets) will not be treated as a new line of business provided that: 
(1) The existing credit claimant used the leased assets in an active 
trade or business for at least five years; (2) the existing credit 
claimant does not through its own officers or staff of employees 
perform management or operational functions (but not including 
operational functions performed through leased employees) with respect 
to the leased assets; and (3) the existing credit claimant does not 
perform marketing functions with respect to the leasing of the assets. 
The income from the leasing of assets will not be income from the 
active conduct of a trade or business, and therefore, the existing 
credit claimant may not receive a possession tax credit with respect to 
such income.
    A second comment asked for clarification as to whether a taxpayer 
seeking to be treated as an existing credit claimant through the 
acquisition of the assets of an existing credit claimant pursuant to 
section 936(j)(9)(A)(ii) must acquire all the assets of the acquired 
corporation even in cases in which the existing credit claimant has 
more than one trade or business. The final regulations have been 
clarified to conform to the language of section 936(j)(9)(A)(ii) and 
provide that an acquiring corporation need only acquire all the assets 
of a single trade or business to be treated as an existing credit 
claimant.
    The third comment asked for clarification as to when the assets of 
a trade or business are measured for purposes of satisfying the 
requirement that all the assets of a trade or business must be acquired 
from an existing credit claimant in order to satisfy section 
936(j)(9)(A)(ii). Specifically, the comment expressed concern that 
assets

[[Page 3815]]

of an existing credit claimant may be sold or otherwise disposed of 
between October 13, 1995, the date on which existing credit claimant 
status is established, and the date of acquisition. In response to the 
comment, the final regulations provide that the assets of a trade or 
business of an existing credit claimant are determined on the date of 
acquisition provided that the transferee actively conducts a trade or 
business in the possession with the acquired assets.

Special Analyses

    It has been determined that this final regulation is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, the 
preceding notice of proposed rulemaking was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its effect on small business.

Drafting Information

    The principal author of this regulation is Daniel S. Karen of the 
Office of the Associate Chief Counsel (International), within the 
office of Chief Counsel, IRS. However, other personnel from the IRS and 
the Department of the Treasury participated in the development of this 
regulation.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for 1.936-11T and by adding an entry in numerical 
order to read as follows:

    Authority:  26 U.S.C. 7805 * * *. Section 1.936-11 also issued 
under 26 U.S.C. 936(j). * * *


Sec. 1.936-11T   


[Removed]   

    Par. 2. Section 1.936-11T is removed.
    Par. 3. Section 1.936-11 is added to read as follows:


Sec. 1.936-11  New lines of business prohibited.

    (a) In general. A possessions corporation that is an existing 
credit claimant, as defined in section 936(j)(9)(A) and this section, 
that adds a substantial new line of business during a taxable year, or 
that has a new line of business that becomes substantial during the 
taxable year, loses its status as an existing credit claimant for that 
year and all years subsequent.
    (b) New line of business--(1) In general. A new line of business is 
any business activity of the possessions corporation that is not 
closely related to a pre-existing business of the possessions 
corporation. The term closely related is defined in paragraph (b)(2) of 
this section. The term pre-existing business is defined in paragraph 
(b)(3) of this section.
    (2) Closely related. To determine whether a new activity is closely 
related to a pre-existing business of the possessions corporation all 
the facts and circumstances must be considered, including those set 
forth in paragraphs (b)(2)(i)(A) through (G) of this section.
    (i) Factors. The following factors will help to establish that a 
new activity is closely related to a pre-existing business activity of 
the possessions corporation--
    (A) The new activity provides products or services very similar to 
the products or services provided by the pre-existing business;
    (B) The new activity markets products and services to the same 
class of customers;
    (C) The new activity is of a type that is normally conducted in the 
same business location;
    (D) The new activity requires the use of similar operating assets;
    (E) The new activity's economic success depends on the success of 
the pre-existing business;
    (F) The new activity is of a type that would normally be treated as 
a unit with the pre-existing business' in the business accounting 
records; and
    (G) The new activity and the pre-existing business are regulated or 
licensed by the same or similar governmental authority.
    (ii) Safe harbors. An activity is not a new line of business if--
    (A) If the activity is within the same six-digit North American 
Industry Classification System (NAICS) code (or four-digit Standard 
Industrial Classification (SIC) code). The similarity of the NAICS or 
SIC codes may not be relied upon to determine whether the activity is 
closely related to a pre-existing business where the code indicates a 
miscellaneous category;
    (B) If the new activity is within the same five-digit NAICS code 
(or three-digit SIC code) and the facts relating to the new activity 
also satisfy at least three of the factors listed in paragraphs 
(b)(2)(i)(A) through (G) of this section; or
    (C) If the pre-existing business is making a component product or 
end-product form, as defined in Sec. 1.936-5(a)(1),Q&A1, and the new 
business activity is making an integrated product, or an end-product 
form with fewer excluded components, that is not within the same six-
digit NAICS code (or four-digit SIC code) as the pre-existing business 
solely because the component product and the integrated product (or two 
end-product forms) have different end-uses.
    (3) Pre-existing business--(i) In general. Except as provided in 
paragraph (b)(3)(ii) of this section, a business activity is a pre-
existing business of the existing credit claimant if--
    (A) The existing credit claimant was actively engaged in the 
activity within the possession on or before October 13, 1995; and
    (B) The existing credit claimant had elected the benefits of the 
Puerto Rico and possession tax credit pursuant to an election which was 
in effect for the taxable year that included October 13, 1995.
    (ii) Acquisition of an existing credit claimant. (A) If all the 
assets of one or more trades or businesses of a corporation of an 
existing credit claimant are acquired by an affiliated or non-
affiliated existing credit claimant which carries on the business 
activity of the predecessor existing credit claimant, the acquired 
business activity will be treated as a pre-existing business of the 
acquiring corporation. A non-affiliated acquiring corporation will not 
be bound by any section 936(h) election made by the predecessor 
existing credit claimant with respect to that business activity.
    (B) Where all of the assets of one or more trades or businesses of 
a corporation of an existing credit claimant are acquired by a 
corporation that is not an existing credit claimant, the acquiring 
corporation may make a section 936(e) election for the taxable year in 
which the assets are acquired with the following effects--
    (1) The acquiring corporation will be treated as an existing credit 
claimant for the year of acquisition;
    (2) The activity will be considered a pre-existing business of the 
acquiring corporation;
    (3) The acquiring corporation will be deemed to satisfy the rules 
of section 936(a)(2) for the year of acquisition; and

[[Page 3816]]

    (4) After making an election under section 936(e), a non-affiliated 
acquiring corporation will not be bound by elections under sections 
936(a)(4) and (h) made by the predecessor existing credit claimant.
    (C) For purposes of this section the assets of a trade or business 
are determined at the time of acquisition provided that the transferee 
actively conducts the trade or business acquired.
    (D) A mere change in the stock ownership of a possessions 
corporation will not affect its status as an existing credit claimant 
for purposes of this section.
    (4) Leasing of Assets.--(i) The leasing of assets (and employees to 
operate leased assets) will not, for purposes of this section, be 
considered a new line of business of the existing credit claimant if--
    (A) the existing credit claimant used the leased assets in an 
active trade or business for at least five years;
    (B) the existing credit claimant does not through its own officers 
or staff of employees perform management or operational functions (but 
not including operational functions performed through leased employees) 
with respect to the leased assets; and
    (C) the existing credit claimant does not perform marketing 
functions with respect to the leasing of the assets.
    (ii) Any income from the leasing of assets not considered a new 
line of business pursuant to paragraph (b)(4)(i) of this section will 
not be income from the active conduct of a trade or business (and, 
therefore, the existing credit claimant may not receive a possession 
tax credit with respect to such income).
    (5) Timing rule. The tests for a new line of business in this 
paragraph (whether the new activity is closely related to a pre-
existing business) are applied only at the end of the taxable year 
during which the new activity is added.
    (c) Substantial--(1) In general. A new line of business is 
considered to be substantial as of the earlier of--
    (i) The taxable year in which the possessions corporation derives 
more than 15 percent of its gross income from that new line of business 
(gross income test); or
    (ii) The taxable year in which the possessions corporation directly 
uses in that new line of business more than 15 percent of its assets 
(assets test).
    (2) Gross income test. The denominator in the gross income test is 
the amount that is the gross income of the possessions corporation for 
the current taxable year, while the numerator is the amount that is the 
gross income of the new line of business for the current taxable year. 
The gross income test is applied at the end of each taxable year. For 
purposes of this test, if a new line of business is added late in the 
taxable year, the income is not to be annualized in that year. In the 
case of a new line of business acquired through the purchase of assets, 
the gross income of such new line of business for the taxable year of 
the acquiring corporation that includes the date of acquisition is 
determined from the date of acquisition through the end of the taxable 
year. In the case of a consolidated group election made pursuant to 
section 936(i)(5), the test applies on a company by company basis and 
not on a consolidated basis.
    (3) Assets test--(i) Computation. The denominator is the adjusted 
tax basis of the total assets of the possessions corporation for the 
current taxable year. The numerator is the adjusted tax basis of the 
total assets utilized in the new line of business for the current 
taxable year. The assets test is computed annually using all assets 
including cash and receivables.
    (ii) Exception. A new line of business of a possessions corporation 
will not be treated as substantial as a result of meeting the assets 
test if an event that is not reasonably anticipated causes assets used 
in the new line of business of the possessions corporation to exceed 15 
percent of the adjusted tax basis of the possessions corporation's 
total assets. For example, an event that is not reasonably anticipated 
would include the destruction of plant and equipment of the pre-
existing business due to a hurricane or other natural disaster, or 
other similar circumstances beyond the control of the possessions 
corporation. The expiration of a patent is not such an event and will 
not permit use of this exception.
    (d) Examples. The following examples illustrate the rules described 
in paragraphs (a), (b), and (c) of this section. In the following 
examples, X Corp. is an existing credit claimant unless otherwise 
indicated:

    Example 1. X Corp. is a pharmaceutical corporation which 
manufactured bulk chemicals (a component product). In March 1997, X 
Corp. began to also manufacture pills (e.g., finished dosages or an 
integrated product). The new activity provides products very similar 
to the products provided by the pre-existing business. The new 
activity is of a type that is normally conducted in the same 
business location as the pre-existing business. The activity's 
economic success depends on the success of the pre-existing 
business. The manufacture of bulk chemicals is in NAICS code 325411, 
Medicinal and Botanical Manufacturing, while the manufacture of the 
pills is in NAICS code 325412, Pharmaceutical Preparation 
Manufacturing. Although the products have a different end-use, may 
be marketed to a different class of customers, and may not use 
similar operating assets, they are within the same five-digit NAICS 
code and the activity also satisfies paragraphs (b)(2)(i)(A), (C), 
and (E) of this section. The manufacture of the pills by X Corp. 
will be considered closely related to the manufacture of the bulk 
chemicals. Therefore, X Corp. will not be considered to have added a 
new line of business for purposes of paragraph (b) of this section 
because it falls within the safe harbor rule of (b)(2)(ii)(B).
    Example 2. X Corp. currently manufactures printed circuit boards 
in a possession. As a result of a technological breakthrough, X 
Corp. could produce the printed circuit boards more efficiently if 
it modified its existing production methods. Because demand for its 
products was high, X Corp. expanded when it modified its production 
methods. After these modifications to the facilities and production 
methods, the products produced through the new technology were in 
the same six-digit NAICS code as products produced previously by X 
Corp. See paragraph (b)(2)(ii)(A) of this section. Therefore, X 
Corp. will not be considered to have added a new line of business 
for purposes of paragraph (b) of this section because it falls 
within the safe harbor rule of (b)(2)(ii)(A).
    Example 3. X Corp. has manufactured Device A in Puerto Rico for 
a number of years and began to manufacture Device B in Puerto Rico 
in 1997. Device A and Device B are both used to conduct electrical 
current to the heart and are both sold to cardiologists. There is no 
significant change in the type of activity conducted in Puerto Rico 
after the transfer of the manufacturing of Device B to Puerto Rico. 
Similar manufacturing equipment, manufacturing processes and skills 
are used in the manufacture of both devices. Both are regulated and 
licensed by the Food and Drug Administration. The economic success 
of Device B is dependent upon the success of Device A only to the 
extent that the liability and manufacturing prowess with respect to 
one reflects favorably on the other. Depending upon the heart 
abnormality, the cardiologist may choose to use Device A, Device B 
or both on a patient. The manufacture of Device B is treated as a 
unit with the manufacture of Device A in X Corp.'s accounting 
records. The manufacture of Device A is in the six-digit NAICS code 
339112, Surgical and Medical Instrument Manufacturing. The 
manufacture of Device B is in the six-digit NAICS code 334510, 
Electromedical and Electrotherapeutic Apparatus Manufacturing. (The 
manufacture of Device A is in the four-digit SIC code 3845, 
Electromedical and Electrotherapeutic Apparatus. The manufacture of 
Device B is in the four-digit SIC code 3841, Surgical and Medical 
Instruments and Apparatus.) The safe harbor of paragraph 
(b)(2)(ii)(B) of this section applies because the two activities are 
within the same three-digit SIC code and Corp. X satisfies 
paragraphs (b)(2)(i)(A), (B), (C), (D), (F), and (G) of this 
section.
    Example 4. X Corp. has been manufacturing house slippers in 
Puerto Rico since 1990. Y Corp. is a U.S. corporation that

[[Page 3817]]

is not affiliated with X Corp. and is not an existing credit 
claimant. Y Corp. has been manufacturing snack food in the United 
States. In 1997, X Corp. purchased the assets of Y Corp. and began 
to manufacture snack food in Puerto Rico. House slipper 
manufacturing is in the six-digit NAICS code 316212 (Four-digit SIC 
code 3142, House Slippers). The manufacture of snack foods falls 
under the six-digit NAICS code 311919, Other Snack Food 
Manufacturing (four-digit SIC code 2052, Cookies and Crackers 
(pretzels)). Because these activities are not within the same five 
or six digit NAICS code (or the same three or four-digit SIC code), 
and because snack food is not an integrated product that contains 
house slippers, the safe harbor of paragraph (b)(2)(ii) of this 
section cannot apply. Considering all the facts and circumstances, 
including the seven factors of paragraph (b)(2)(i) of this section, 
the snack food manufacturing activity is not closely related to the 
manufacture of house slippers, and is a new line of business, within 
the meaning of paragraph (b) of this section.
    Example 5. X Corp., a calendar year taxpayer, is an existing 
credit claimant that has elected the profit-split method for 
computing taxable income. P Corp. was not an existing credit 
claimant and manufactured a product in a different five-digit NAICS 
code than the product manufactured by X Corp. In 1997, X Corp. 
acquired the stock of P Corp. and liquidated P Corp. in a tax-free 
liquidation under section 332, but continued the business activity 
of P Corp. as a new business segment. Assume that this new business 
segment is a new line of business within the meaning of paragraph 
(c) of this section. In 1997, X Corp. has gross income from the 
active conduct of a trade or business in a possession computed under 
section 936(a)(2) of $500 million and the adjusted tax basis of its 
assets is $200 million. The new business segment had gross income of 
$60 million, or 12 percent of the X Corp. gross income, and the 
adjusted basis of the new segment's assets was $20 million, or 10 
percent of the X Corp. total assets. In 1997, X Corp. does not 
derive more than 15 percent of its gross income, or directly use 
more that 15 percent of its total assets, from the new business 
segment. Thus, the new line of business acquired from P Corp. is not 
a substantial new line of business within the meaning of paragraph 
(c) of this section, and the new activity will not cause X Corp. to 
lose its status as an existing credit claimant during 1997. In 1998, 
however, the gross income of X Corp. grew to $750 million while the 
gross income of the new line of business grew to $150 million, or 
20% of the X Corp. 1998 gross income. Thus, in 1998, the new line of 
business is substantial within the meaning of paragraph (c) of this 
section, and X Corp. loses its status as an existing credit claimant 
for 1998 and all years subsequent.

    (e) Loss of status as existing credit claimant. An existing credit 
claimant that adds a substantial new line of business in a taxable 
year, or that has a new line of business that becomes substantial in a 
taxable year, loses its status as an existing credit claimant for that 
year and all years subsequent.
    (f) Effective date--(1) General rule. This section applies to 
taxable years of a possessions corporation beginning on or after 
January 25, 2000.
    (2) Election for retroactive application. Taxpayers may elect to 
apply retroactively all the provisions of this section for any open 
taxable year beginning after December 31, 1995. Such election will be 
effective for the year of the election and all subsequent taxable 
years. This section will not apply to activities of pre-existing 
businesses for taxable years beginning before January 1, 1996.

David Mader,
Acting Deputy Commissioner of Internal Revenue.
    Approved: January 12, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-1528 Filed 1-21-00; 8:45 am]
BILLING CODE 4831-01-U