United States Court of Appeals

For the First Circuit

____________________

No. 01-2251

MEDCHEM (P.R.), INC.,

Petitioner, Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent, Appellee.

____________________

APPEAL FROM THE UNITED STATES TAX COURT

[Hon. David Laro, U.S. Tax Court Judge]

____________________

Before

Selya, Circuit Judge,

Stahl, Senior Circuit Judge,

and Lynch, Circuit Judge.

____________________

David A. Hickerson with whom Lisa R. Fine and Weil, Gotshal &

Manges, LLP were on brief for appellant.

A. Duane Webber and Baker & McKenzie on brief for Electronic

Arts Puerto Rico, Inc., amicus curiae. 

David English Carmack, Attorney, Tax Division, Department of

Justice, with whom Eileen J. O'Connor, Assistant Attorney General,

and Kenneth W. Rosenberg, Attorney, Tax Division, Department of

Justice, were on brief for appellee. 

____________________

July 10, 2002

____________________
1 Section 936(a)(2)'s other condition is that at least 80%

of the corporation's gross income for the three-year period

immediately preceding the close of the tax year must be "derived

from sources within a possession of the United States." 26 U.S.C.

§ 936(a)(2)(A). The parties agree that MedChem (P.R.) meets this

requirement.

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LYNCH, Circuit Judge. This tax case requires

interpretation of the Internal Revenue Code's Puerto Rico and

Possession Tax Credit provision, 26 U.S.C. § 936 (2000), which

permits a domestic corporation to elect a possession tax credit if

it meets certain conditions, id. § 936(a). The condition on which

this case turns is that 75% or more of the gross income of the

corporation for the three preceding years must be "derived from the

active conduct of a trade or business within a possession of the

United States." Id. § 936(a)(2)(B).1 

The taxpayer, MedChem (P.R.), Inc. ("M-PR"), contends

that it meets this "active conduct of a trade or business"

requirement; the Tax Court and the Commissioner of Internal Revenue

disagree. This issue appears to be one of first impression at the

circuit level.

The particular tax credit codified at § 936 was added by

the Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520

(1976) (codified in scattered sections of 26 U.S.C.), although it

has its roots in legislation from the 1920s, see Revenue Act of

1921, Pub. L. No. 67-98, § 262, 42 Stat. 227, 271 (1921). The

government tells us that the tax credit is in the process of being

phased out. See 26 U.S.C. § 936(j). This case has, in the

interim, consequences for domestic corporations involved in
2 Puerto Rico is a Commonwealth; it is explicitly within

the term "possession" for purposes of § 936. 26 U.S.C. § 936(d)(1)

("The term 'possession of the United States' includes the

Commonwealth of Puerto Rico . . . ."). 

-3-

business activity in Puerto Rico2 and certain other possessions.

Unfortunately, there are no promulgated regulations under § 936(a)

and domestic corporations have been forced to make business

arrangements in U.S. possessions without the prior guidance such

regulations might provide.

Based primarily on § 936's text, understood in the

context of the legislative history, we conclude that M-PR has

failed to meet the "active conduct of a trade or business"

requirement and, accordingly, we affirm the Tax Court's judgment.

We do so without adopting the Tax Court's proposed test for what

constitutes the active conduct of a trade or business in a U.S.

possession for purposes of § 936(a). 

I.

The facts in this case are not in dispute, MedChem

(P.R.), Inc. v. Comm'r, 116 T.C. 308, 310 (2001); see generally Tax

Ct. R. 122, although M-PR contests the inferences the Tax Court

drew from the stipulated record. M-PR is the taxpayer claiming to

qualify for the possessions tax credit. 

M-PR's identity has gone through several transformations.

M-PR was incorporated in Delaware on December 8, 1987, as MedChem

Puerto Rico, Inc. A couple of weeks later, on December 22, MedChem

Puerto Rico, Inc. changed its name to BioChem Products, Inc. Then,

on March 1, 1992, BioChem Products, Inc. changed its state of
3 When we refer to the "tax years at issue" or the "subject

years of this case," we mean the three-year period made relevant by

§ 936(a)(2). That is, the three-year period "immediately preceding

the close of the taxable year." Here, because the alleged

deficiency occurred for the tax year ending August 31, 1992, the

three-year period runs from September 1, 1989, through August 31,

1992. 

4 The Tax Court states that the deficiency was $815,196.

MedChem, 116 T.C. at 309. In contrast, both parties, at various

points in their briefs, state that the sum is $815,916. The Notice

of Deficiency uses both figures. We assume that $815,196 is the

correct figure.

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incorporation to Massachusetts and, on November 25, 1992, changed

its name to MedChem P.R., Inc. M-PR and all of its predecessors --

all of which we will refer to as M-PR -- were at all times wholly

owned subsidiaries of MedChem Products, Inc. ("M-USA"). M-USA is

a Massachusetts corporation with its principal place of business in

Woburn, Massachusetts. Following the tax years at issue in this

case,

3 M-USA succeeded M-PR through a merger of M-PR into M-USA. 

The IRS found a deficiency of $815,1964 in M-PR's federal

income tax paid for the tax year ending August 31, 1992, and a

deficiency of $1,705,019 in M-USA's tax payments for the same

period. In consolidated cases in the Tax Court, M-USA, as

successor by merger to M-PR, contested both of these claims of

deficiency. MedChem, 116 T.C. at 309. It is the $815,196

liability that is at issue here. 

During the relevant three-year period -- that is, during

each of M-PR's taxable years ending on August 31, 1990-92 -- all of

M-PR's reported income was "intangible property income," see 26

U.S.C. § 936(h)(3), attributable to the sale of Avitene, a blood-
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clotting drug manufactured by Alcon Puerto Rico, Inc. ("A-PR"), an

unrelated company.

On December 18, 1987, ten days after M-PR was

incorporated, A-PR along with Alcon Pharmaceuticals, Ltd. and Alcon

Laboratories, Inc. (collectively "Alcon entities") sold the Avitene

portion of their business to M-PR and M-USA. The Alcon entities

sold the equipment, raw materials, technology, and other assets

associated with Avitene's manufacturing. M-USA acquired the

receivables, non-competition agreements, goodwill, contract rights,

records, patents and related know-how, trademarks, and Food and

Drug Administration approvals. M-PR acquired receivables,

inventory, and title to the machinery and equipment located within

A-PR's manufacturing facility in Humacao, Puerto Rico. Those

assets did not include A-PR's Avitene manufacturing facility in

Humacao. 

Before the acquisition, A-PR had been the manufacturer of

Avitene. M-USA had nothing to do with the drug. Until ten days

prior to the acquisition, M-PR did not exist. As part of the sale,

A-PR agreed to continue manufacturing Avitene for M-PR using A-PR's

own facility and labor and M-PR's recently-acquired raw materials

and equipment. A-PR also used the technology acquired by M-USA.

M-PR held title to the in-process and finished Avitene. A-PR

shipped finished Avitene from its facility to M-USA, and title

passed to M-USA, the purchaser. A-PR was solely responsible for

any issues that arose until the finished product was delivered to

a carrier for shipment to M-USA. In return, A-PR sent its invoices
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for its manufacturing services directly to M-USA, which paid, from

M-PR's account, a price equal to the manufacturing cost plus 10%.

The primary change effected by the 1987 sale was that certain

assets were held in the name of either M-PR or its parent, M-USA.

The reason M-PR entered into the processing agreement

with A-PR, in which A-PR manufactured Avitene for M-PR using M-PR's

raw materials and equipment, was that M-PR needed to ensure a

steady supply of Avitene until it built its own manufacturing

facility in Puerto Rico. As it turns out, M-PR later abandoned its

plan to construct its own Avitene facility in Puerto Rico. 

During much of the relevant three-year period, M-PR had

no employees. Its one employee, Mr. Perez, was a former A-PR

employee. He worked for M-PR from March 1988 to June 1990 out of

a one-room office that M-PR maintained. Mr. Perez spent much of

his time planning M-PR's transition to its own Avitene

manufacturing facility. M-PR also paid three independent

contractors to assist Mr. Perez. M-PR treated the independent

contractors as nonemployees for payroll and tax purposes. M-USA

and A-PR employed the individuals, other than Mr. Perez and the

independent contractors, associated with the Avitene manufacturing

and sales business. 

At the time of the 1987 processing agreement, M-PR and MUSA had hoped to establish their own manufacturing facility in

Puerto Rico. M-PR purchased land in Puerto Rico, on which it

planned to build its own Avitene manufacturing facility. In early

1990 M-USA suffered financial reverses causing it to lay off a
-7-

third of its workforce and to default on $10 million in debt. As

a result, M-PR suspended its plans to construct a manufacturing

facility in Puerto Rico. M-PR then wrote off its capital

expenditures that had been made on the new facility and closed its

Puerto Rico office. When the office closed, Perez transferred MPR's business records to A-PR and M-USA. As of July 1, 1990, all

M-PR checks were issued by M-USA from M-USA's Woburn, Massachusetts

office. 

In early 1990 M-USA decided to move the manufacturing

equipment and processes from A-PR's Humacao facility to M-USA's

facility in Woburn. Significant elements of the equipment were

moved from Humacao to Woburn by June 1990 and, by January 1991, all

of the manufacturing equipment necessary to perform the first phase

of the manufacturing process had been moved to Woburn. In October

1992, first-phase Avitene production commenced in Woburn. By April

1994, M-USA had substantially completed the construction, in

Woburn, of its Avitene finished goods manufacturing facility.

II.

For its tax year ending August 31, 1992, M-PR claimed a

tax credit under § 936. The Commissioner determined that M-PR's

Avitene income was not "derived from the active conduct of a trade

or business" within a possession as § 936(a)(2)(B) requires.

Accordingly, the Commissioner issued a notice of deficiency in the

amount of $815,196.

M-USA, as successor by merger to M-PR, contested the

asserted deficiency. On June 27, 2001, the Tax Court entered its
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final decision, finding that M-PR was deficient, in the sum of

$815,196, in its federal income tax payments. The Tax Court

concluded that M-PR did not meet § 936(a)(2)(B)'s "active conduct

of a trade or business within a possession" requirement. MedChem,

116 T.C. at 309, 328-29. The Tax Court held that 

for purposes of section 936(a), a taxpayer actively

conducts a trade or business in a U.S. possession only if

it participates regularly, continually, extensively, and

actively in the management and operation of its profitmotivated activity in that possession. . . . [F]or the

purpose of this participation requirement, the services

underlying a manufacturing contract may be imputed to a

taxpayer only to the extent that the performance of those

services is adequately supervised by the taxpayers's own

employees.

Id. at 336-37. 

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

Id. at 337. It concluded that A-PR and M-USA (located in a

mainland U.S. facility) performed, directed, and controlled all of

the business activities related to the manufacture of Avitene. Id.

at 339. The Tax Court found that, under the processing agreement,

A-PR used its own personnel to manufacture, test, and package the

Avitene at its Humacao facility. Id. at 317. A-PR employees

performed all of the tasks required in the manufacturing process,

including the supervision of that manufacturing. Id. at 317, 339.

It was M-USA which distributed, marketed, and sold the drug in the

United States. Id. at 339. Indeed, the processing agreement

prohibited M-PR from taking a managerial role in the manufacturing

process. Id. at 346. Any risks associated with M-PR's activities

appear to be minimal, as M-USA had guaranteed payment of any debt,

and performance of any of M-PR's obligations, arising from the
5 Had the Treasury Department promulgated a regulation

interpreting § 936(a), we would have been required, absent

contradictory statutory language, to defer to a reasonable

interpretation. Kikalos v. Comm'r, 190 F.3d 791, 795-96 (7th Cir.

1999); Snowa v. Comm'r, 123 F.3d 190, 195-96 (4th Cir. 1997). 

-9-

asset purchase agreements. Id. at 316. M-USA consistently

reported, including to the FDA and to the SEC, that the unrelated

entity, A-PR, was the drug's manufacturer. Id. This information

was also contained on the labels of the drugs. Id. at 315-16. 

M-PR appeals the Tax Court's decision. 

III.

A. Standard of Review

This court reviews the Tax Court's decisions "in the same

manner and to the same extent as decisions of the district courts

in civil actions tried without a jury." 26 U.S.C. § 7482(a)(1)

(2000); see also Silverman v. Comm'r, 86 F.3d 260, 261 (1st Cir.

1996). Our standard of review is two-fold. We review de novo the

Tax Court's statutory and other legal interpretations. Alexander

v. IRS, 72 F.3d 938, 941 (1st Cir. 1995). We review its factual

findings, including those based on inferences from stipulated

facts, for clear error. Manzoli v. Comm'r, 904 F.2d 101, 103 (1st

Cir. 1990). To the extent that M-PR is making a clear error

argument with respect to the Tax Court's factual findings, we

reject the argument.

There are no Treasury Department regulations interpreting

§ 936(a),5 nor is the term "active conduct of a trade or business"

defined for purposes of § 936. There are, however, some guides to
6 We are not persuaded by M-PR's contention that, if § 936

is ambiguous, then this court should strictly construe it against

the government. Here, we are interpreting a provision permitting

a tax credit, not a provision levying a tax. The Supreme Court has

stated that in the context of a tax deduction, it is "not impressed

by the argument that . . . all doubts should be resolved in favor

of the taxpayer." White v. United States, 305 U.S. 281, 292

(1938); see also United States v. Stewart, 311 U.S. 60, 71 (1940)

(stating that "those who seek an exemption from a tax must rest it

on more than a doubt or ambiguity"); Inter-Mountain Life Ins. Co.,

294 U.S. at 689-90 (holding that deductions must be plainly

authorized, not derived from ambiguities). Rather, it is the duty

of a court to determine "what [the] construction [of a statute]

fairly should be." White, 305 U.S. at 292. M-PR's argument would

be more appropriate were this a case involving a statute imposing

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statutory interpretation, which assist us. "It is well established

in the tax law that an [IRS determination that a taxpayer owes the

Federal Government a certain amount of unpaid taxes] is entitled to

a legal presumption of correctness -- a presumption that can help

the Government prove its case against a taxpayer in court." United

States v. Fior D'Italia, Inc., No. 01-463, 2002 U.S. LEXIS 4418, at

*9-10 (U.S. June 17, 2002). Furthermore, income tax deductions and

credits are matters of legislative grace; the taxpayer bears the

burden of proving entitlement to any deduction or credit claimed.

Indopco, Inc. v. Comm'r, 503 U.S. 79, 84 (1992); New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934); Norfolk S. Corp. v.

Comm'r, 104 T.C. 13, 36 (investment tax credit), supplemented by

104 T.C. 417 (1995), aff'd, 140 F.3d 240 (4th Cir. 1998).

Moreover, a deduction or credit should be allowed only where there

is "clear provision therefor." New Colonial Ice Co., 292 U.S. at

440; see also Helvering v. Inter-Mountain Life Ins. Co., 294 U.S.

686, 689 (1935) (stating that "[d]eductions are allowed only when

plainly authorized").

6 
a tax, rather than a statute permitting a tax credit.

-11-

B. Positions of the Parties

The parties have presented the court with different

interpretations of the meaning of § 936(a). The Tax Court has, in

its ruling, left each side dissatisfied. Both sides'

interpretations diverge from the Tax Court's, although the

government's position is much closer to the Tax Court's conclusion.

The Tax Court rejected M-PR's statutory plain meaning

argument. MedChem, 116 T.C. at 328-29. Instead, it crafted a test

that, in the absence of a statutory or regulatory definition of

"active conduct of a trade or business" for purposes of § 936(a),

looks to regulations defining the phrase as it is used elsewhere in

the code, bearing in mind the section's legislative intent, id. at

330-33. Applying this test, the Tax Court rejected interpretations

more helpful to the taxpayer, provided in other regulations, see,

e.g., 26 C.F.R. § 1.936-5(c) (2001). The applicable test, the Tax

Court held, was whether the taxpayer "participates regularly,

continually, extensively, and actively in the management and

operation of its profit-motivated activity in that possession."

MedChem, 116 T.C. at 336. It held that to impute a contractor's

activities to the taxpayer, the taxpayer had to "adequately

supervise[]" the provision of these services with its own

employees. Id. at 337. The Tax Court found the facts about M-PR's

relationship with the contract manufacturer inadequate under its
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newly crafted test, and thus found that M-PR is not entitled to the

credit. Id. at 337-43.

The Commissioner rejects M-PR's "plain meaning" reading

of the statute and generally rejects the proposition that use of

contract manufacturers in possessions is ever sufficient to qualify

for the § 936(a) tax credit, but allows for rare exceptions where

the taxpayer corporation is very heavily involved in the operation

and management of the contract manufacturer. The Commissioner

seeks affirmance of the Tax Court's result, but at oral argument

protested the Tax Court's test, which is more beneficial to

taxpayers than the IRS's proposed test for what constitutes the

active conduct of a trade of business. The IRS proposes that

outsourced manufacturing may never (well, hardly ever) qualify for

the tax credit. Only in rare instances, when the taxpayer is

heavily involved in the management and control of operations of a

contract manufacturer, says the IRS, might it qualify.

The taxpayer, M-PR, on the other hand, argues that the

statute's plain meaning does not preclude tax credits to taxpayers

who use contract manufacturers located in the possessions and that,

if more were required, it has, on the facts, provided the requisite

more. M-PR says the Tax Court is wrong in its statutory

interpretation and in its choice of test. M-PR asserts that the

Tax Court's test is inconsistent with regulations applicable to

other parts of § 936.

We affirm the denial of the credit and the finding of

deficiency. In doing so, we assess and reject the taxpayer's plain
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meaning arguments, look to the Act's legislative history for

further guidance regarding congressional intent in enacting § 936,

and compare the section at issue with the now-repealed Western

Hemisphere Trade Corporation provisions of the Internal Revenue

Code of 1954. We conclude that, on the facts presented, M-PR does

not fall within the language of the statute or Congress's intent.

We do so without adopting the Tax Court's proposed test. 

C. The Statute and Plain Meaning

Before analyzing the statute, we think it helpful to

understand the context in which the statutory interpretation

question arises. "Possessions corporations . . . are U.S.-

chartered companies that are effectively exempt under section 936

of the Internal Revenue Code from Federal tax on business income

and qualified passive investment income from Puerto Rico and

certain other U.S. possessions." Dep't of the Treasury, The

Operation and Effect of the Possessions Corporation System of

Taxation, Sixth Report 1 (1989) (footnotes omitted).

The Treasury Department has described the general

operation of the possessions corporation tax system:

The possessions corporation system of taxation is a set

of rules under which a U.S. corporation deriving

qualifying income from possessions and Puerto Rico pays

no income tax to the United States. As a U.S.

corporation, a possessions corporation is subject to

federal tax on its worldwide income. However, a special

credit available under section 936 fully offsets the

federal tax on income from a trade or business in Puerto

Rico and from qualified possession source investment

income (QPSII). A U.S. parent corporation can, in turn,

offset dividends received from a wholly owned 936

subsidiary with a 100 percent dividends-received
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deduction, which frees the dividend income from federal

tax.

Id. at 5.

With this context, we turn to the statutory language.

The code section at issue provides, in relevant part:

§ 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 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 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.

26 U.S.C. § 936(a)(1)-(2). A separate subsection of § 936 governs

the tax treatment of possessions corporations' intangible property
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income. 26 U.S.C. § 936(h). The Treasury Department has issued

regulations under § 936(h), see 26 C.F.R. §§ 1.936-4 to -7 (2001),

although not under § 936(a). It is the § 936(a) "derived from the

active conduct of a trade or business" language that is at issue

here. 26 U.S.C. § 936(a)(2)(B). 

M-PR argues that § 936(a) "requires only that the

taxpayer derive its income from an active business rather than a

passive investment." Its argument is really two-fold: first, that

"active conduct" means all non-passive conduct; second, that the

taxpayer corporation need only derive its income from some nonpassive source, meaning that the taxpayer can qualify by deriving

its income from the active conduct of a third party rather than

from the taxpayer's own active conduct. This interpretation, if

accepted, would mean that a domestic corporation that gets its

income from the sale of a pharmaceutical product manufactured by a

contract manufacturer in Puerto Rico, as here, would qualify for

the tax credit. We deal with each argument in turn, rejecting both

parts as contrary to the text of the statute. 

First, M-PR's interpretation, construing income "derived

from the active conduct of a trade or business" to mean income

"derived from an active, rather than passive, business," renders

the statutory term "active" surplusage. The phrase "active conduct

of a trade or business" does not mean that all income derived from

anything that is not a passive investment qualifies for the
7 M-PR notes that the Commissioner has previously taken the

position that the "active conduct" requirement is meant to

distinguish between investment income and business income. That

proposition is different from the proposition M-PR urges here,

which is that the "active conduct" requirement is met so long as

the taxpayer derives income from any source not wholly passive. To

say that the "active conduct" requirement distinguishes investment

income from business income is not to say that all income other

than investment income meets the requirement. 

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credit.7 We accept the Commissioner's view that the phrase

"conduct of a trade or business" alone, without the term "active,"

distinguishes section 936(a) income from passive investment income.

M-PR's construction renders the term "active" redundant. That is

not a permissible form of interpretation. E.g., New England Power

& Marine, Inc. v. Town of Tyngsborough (In re Middlesex Power

Equip. & Marine, Inc.), No. 01-2314, 2002 WL 1248226, at *4 (1st

Cir. June 11, 2002) (stating that "[w]e assume each term was meant

to have separate content in order to avoid redundancy"). 

Given that the statutory term "active" is not surplusage,

we must determine what independent meaning it adds to the statutory

phrase "active conduct." Because "active" modifies "conduct," we

conclude that "active conduct" means something more than simply a

minimal level of involvement in the process of conducting a trade

or business. Not all conduct of a trade or business qualifies

under § 936(a)(2)(B); only "active conduct" qualifies. Because the

"conduct of a trade or business" itself requires some level of

activity, the adjective "active" must, in context, signify

something more than a non-zero level of activity.

The Oxford English Dictionary's first definition of the

noun "conduct" is "[t]he action of conducting or leading," and, as
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the term relates to a business, it is defined as "[t]he action or

manner of conducting, directing, managing, or carrying on (any

business . . . etc.)." Oxford English Dictionary (2d ed. 1989),

http://dictionary.oed.com. Similarly, Webster's defines the noun

"conduct" as "the act, manner, or process of carrying out . . . or

carrying forward (as a business, government, or war)." Webster's

Third New International Dictionary of the English Language

Unabridged 473 (P.B. Gove et al. eds. 1993). "Active," in turn, is

generally defined as "[c]haracterized by action" and is defined in

terms such as "[o]riginating or communicating action," "practical,"

"working, effective, having practical operation or results."

Oxford English Dictionary, supra; see also Webster's Third New

International Dictionary of the English Language Unabridged, supra,

at 22 (defining "active" as "characterized by action rather than by

contemplation or speculation"). 

The mere act, without more, of purchasing products that

another unrelated entity has taken the action to manufacture, and

reselling the products to others outside the possession, does not

fit within the meaning of "active conduct of a trade or business."

In such a case, it is the unrelated entity controlling and

directing the manufacturing that is actively conducting the trade

or business. 

Here, the Tax Court was "not even able to find that MP.R. had any meaningful business activity in Puerto Rico."

MedChem, 116 T.C. at 337. It found that M-PR's "involvement in

Puerto Rico during the 3-year period failed even to qualify as a
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trade or business in Puerto Rico," id. at 338, never mind as an

actively conducted trade or business. It concluded that A-PR and

M-USA, but not M-PR, directed and controlled "[a]ll of the business

activities connected to Avitene," id., and that A-PR "performed

every task required in the manufacturing process," without the

ability of M-PR "to manage, direct, or control any part of the

manufacturing process," id. at 339. These findings were not

clearly erroneous. On these facts, we are confident in the

conclusion that M-PR did not itself actively conduct a trade or

business. 

The remaining question is whether A-PR's manufacturing

activities may be attributed to M-PR for the purposes of § 936(a).

The answer to this question hinges on M-PR's second claim, that the

statutory phrase requires only that the income "derived" by the

taxpayer be from some third party engaged in the active conduct of

a trade or business. We reject this claim as well. Both the Tax

Court and the Commissioner interpret § 936(a) as requiring that the

taxpayer, not someone else, be the entity engaged in the active

conduct of a trade or business. We agree.

First, this reading is the most natural reading of the

statutory requirement that at least 75% of the taxpayer's gross

income during the relevant period be "derived from the active

conduct of a trade or business within a possession of the United

States." 26 U.S.C. § 936(a)(2)(B). M-PR correctly notes that

Congress could have more explicitly said, "the active conduct by

the taxpayer of a trade or business" and it did not. But Congress
-19-

might have concluded that the addition of the phrase would be

redundant, given the preceding discussion and especially given that

the taxpayer corporation is the only actor referenced in §

936(a)(1)-(2). Congress could also have said "the active conduct

by the taxpayer or any contract manufacturer of a trade or

business," which is M-PR's reading, and it did not. Viewed

myopically, the statutory phrase is silent on whose "active conduct

of a trade or business" it refers to, but, viewed in context, the

best reading is that it means the taxpayer's own active conduct.

Ambiguity in this instance does not assist M-PR because a deduction

or credit should be allowed only where there is "clear provision

therefor." New Colonial Ice Co., 292 U.S. at 440. M-PR has simply

not met its burden of proving entitlement to the § 936 credit

claimed.

To read the statute as requiring only that the income be

derived from a third party's active conduct would eliminate the

distinction between active conduct income and all other income,

including passive investment income. Virtually all passive

investment income, for example, is derived, somewhere down the

chain, by some entity's active conduct of a trade or business. 

Finally, as discussed below, the legislative history

confirms Congress's intent to require the taxpayer claiming the

credit to itself be engaged in the active conduct of a trade or

business. If M-PR's interpretation were correct, then upon the

1976 enactment of § 936, see Tax Reform Act of 1976, Pub. L. No.

94-455, § 1051, 90 Stat. 1520, 1643-47 (1976) (current version at
-20-

26 U.S.C. § 936 (2000)), all domestic corporations that had

contract manufacturers in Puerto Rico (and otherwise met the

numerical requirements) would automatically have become eligible

for the tax credit. This is, in our view, highly improbable on its

face. It is particularly improbable given the legislative history

discussed below.

D. Legislative History and Western Hemisphere Trading

 Corporations

1. Legislative history. 

As stated above, at issue in this case is the proper

interpretation of § 936's "active conduct of a trade or business"

language. Section 936 in general, and the "active conduct of a

trade or business" language in particular, have their roots in much

older legislation. Before analyzing the legislative history as it

pertains to the meaning of the relevant statutory phrase, we

describe § 936's predecessors. 

Both § 936 and the basic structure of today's possessions

corporation tax system have their genesis in a provision of the

Revenue Act of 1921. See Revenue Act of 1921, Pub. L. No. 67-98,

§ 262, 42 Stat. 227, 271 (1921). The phrase we interpret --

"derived from the active conduct of a trade or business" -- first

appeared in the Revenue Act of 1921, though in a slightly different

context. Compare id. with 26 U.S.C. § 936(a)(2)(B). The 1921 Act

exempted a domestic corporation from federal taxes on foreignsource income if, for the three years preceding the close of the

taxable year, it derived at least 80% of its gross income from
8 The 1954 Internal Revenue Code provided, in relevant

part:

Sec. 931. Income From Sources Within Possessions of the

United States.

(a) General Rule. -- In the case of citizens of the

United States or domestic corporations, gross income

means only gross income from sources within the United

States if the conditions of both paragraph (1) and

paragraph (2) are satisfied:

-21-

sources within a possession and 50% or more of its gross income

"from the active conduct of a trade or business" within the

possessions. § 262, 42 Stat. at 271. Congress enacted this

section of the 1921 Act to eliminate the competitive disadvantage

that U.S. corporations were suffering as a result of double

taxation of income earned outside the U.S. and to encourage U.S.

business investments in U.S. possessions. See S. Rep. No. 67-275

(1921), reprinted in 1939-1 C.B. (pt. 2) 181, 187; see generally

Coca-Cola Co. v. Comm'r, 106 T.C. 1, 21 (1996) (describing the 1921

Act and its progeny); N.H. Kaufman, Comment, Puerto Rico's

Possessions Corporations: Do the TEFRA Amendments Go Too Far?, 1984

Wis. L. Rev. 531, 533-37 (same). 

Congress carried forward, without material change, the

1921 Act's possessions corporation exemption into section 931 of

the Internal Revenue Code of 1954. See Internal Revenue Code of

1954, Pub. L. No. 83-591, § 931, 68A Stat. 3, 291 (1954). Section

931 used the same language as the 1921 Act's section 262,

requiring, among other things, that 50% or more of the

corporation's gross income be "derived from the active conduct of

a trade or business." § 931(a)(2), 68A Stat. at 291.8 Section 931
(1) Three-year period. -- If 80 percent or more of

the gross income of such citizen or domestic

corporation (computed without the benefit of this

section) for the 3-year period immediately

preceding the close of the taxable year . . . was

derived from sources within a possession of the

United States; and

(2) Trade or business. -- If --

(A) in the case of such corporation, 50

percent or more of its gross income (computed

without the benefit of this section) for such

period . . . was derived from the active

conduct of a trade or business within a

possession of the United States . . . . 

§ 931, 68A Stat. at 291.

9 Section 936 did not entirely replace section 931. The

then-existing provision -- 26 U.S.C. § 931 -- was retained, but

only for qualifying "individual citizens," as opposed to

corporations. In addition, it was made inapplicable to Puerto Rico

by defining "possession," for purposes of section 931, not to

include Puerto Rico. § 1051(c), 90 Stat. at 1645. In the case of

domestic corporations deriving the requisite income from Puerto

Rico and deriving the requisite income from active conduct of a

trade or business in Puerto Rico, the § 936 credit is available.

See 26 U.S.C. § 936. In the case of qualifying U.S. individual

citizens, the Puerto Rican source income exclusion is now contained

in 26 U.S.C. § 933. 

-22-

remained in effect without material change until the mid-1970s,

when Congress enacted legislation approximating the current version

of 26 U.S.C. § 936. See G.D. Searle & Co. v. Comm'r, 88 T.C. 252,

350-52 (1987) (describing the genesis of § 936). 

Section 1051 of the 1976 Tax Reform Act added a new U.S.

Code section, 26 U.S.C. § 936. See Tax Reform Act of 1976, Pub. L.

No. 94-455, § 1051, 90 Stat. 1520, 1643-47 (1976) (current version

at 26 U.S.C. § 936 (2000)). Section 936 partially replaced section

931, as it relates to Puerto Rico.9 See id. The 1976 legislation
10 Since 1976, there have been many amendments to the

possessions corporations taxation system in general and to § 936 in

particular, including those imposed by the Tax Equity and Fiscal

Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324

(1982), and by the Tax Reform Act of 1986, Pub. L. No. 99-514, 100

Stat. 2085 (1986). We do not analyze these changes. The text of

the provision we construe, 26 U.S.C. § 936(a)(2)(B), has remained

unchanged since 1976, except that its 50% "trade or business"

requirement is now a 75% requirement.

-23-

effected a number of revisions in prior law. To focus on the

revision central to this case, the new § 936 transformed the old

section 931 exemption mechanism into a tax credit. The credit

permits domestic corporations to offset U.S. taxes on income

"derived from the active conduct of a trade or business" in Puerto

Rico, if certain prerequisites are met. § 1051(b), 90 Stat. at

1644.10 We rely on the Treasury Department's 1989 Report, which

described the transition from the 1921 Act to the 1976 Act:

The possessions corporation exemption remained unchanged

until the Tax Reform Act of 1976. Many U.S. firms

established plants in Puerto Rico after 1948, when Puerto

Rico enacted a program of tax exemption for manufacturing

firms. Before the 1976 Act was implemented, proponents

of continued U.S. tax exemption argued that the

possessions corporation system of taxation was needed to

offset the U.S. minimum wage requirement, the requirement

to use U.S. flag vessels in transporting goods to the

United States, and other Federally imposed requirements

that tended to reduce Puerto Rico's ability to compete

with neighboring countries for U.S. investment.

By enacting the Tax Reform Act of 1976, Congress wanted

to leave undisturbed the tax exemption of earnings from

a trade or business in Puerto Rico or from investments

made with those earnings for Puerto Rican use. At the

same time, Congress wished to end the exemption for

passive income from funds invested in foreign capital

markets and to hasten their repatriation if not used in

the possession. . . .

To continue promoting Puerto Rico's industrial

development, the Tax Reform Act of 1976 therefore left

intact the exemption for income derived by U.S.
-24-

corporations from operations in a possession. It also

exempted from tax the dividends remitted by a possessions

corporation to its U.S. parent. To prevent the avoidance

of tax on income invested in foreign countries by

possessions corporations, however, the Tax Reform Act

eliminated the exemption for income derived outside the

possessions. The changes in the tax treatment of

possessions corporations were effected by removing

possessions corporations from section 931 of the Internal

Revenue Code and placing them into a newly created Code

section 936.

The Operation and Effect of the Possessions Corporation System of

Taxation, supra, at 6.

As to the problem before us, the Treasury Report

described the effect of the change:

Change in the scope of and method of effecting the tax

exemption. Before 1976, a possessions corporation was

exempt from U.S. tax on all income derived from sources

outside the United States. Under the Tax Reform Act of

1976, the exemption was limited to two kinds of income:

-- Income from the active conduct of a trade or

business in a possession, or from the sale or

exchange of substantially all of the assets used

by the corporation in the active conduct of such

trade or business; and

-- QPSII, which is non-business income derived from

the possession in which the corporation has its

trade or business and which is attributable to

the investment of funds derived from such trade

or business for use within the possession.

Rather than exempting the income from U.S. taxation,

section 936 provides a credit equal to (and, therefore,

fully offsetting) the U.S. tax on the income. The

section 936 credit is not available for other income

earned by a possessions corporation. However, a regular

foreign tax credit may be claimed for foreign (including

possession) taxes paid or accrued with respect to income

that does not qualify for the 936 credit.

Id. at 7 (footnote omitted).
-25-

The House and Senate Reports are virtually identical on

the pertinent provision. See H.R. Rep. No. 94-658, at 253-60

(1975), reprinted in 1976 U.S.C.C.A.N. 2897, 3149-56; S. Rep. No.

94-938, at 277-84 (1976), reprinted in 1976 U.S.C.C.A.N. 3438,

3707-13. The Reports discuss the tax treatment of corporations

conducting trade or business in possessions of the U.S. as well as

issues arising under the now-repealed Western Hemisphere Trade

Corporation provisions of the Internal Revenue Code of 1954,

§§ 921-922, 68A Stat. at 290-91 (repealed in 1976 for taxable years

after 1979). See H.R. Rep. No. 94-658 at 253-60; S. Rep. No. 94-

938 at 277-84.

Describing the law as it existed prior to the enactment

of the Tax Reform Act of 1976, the House and Senate Reports recite

that 

[u]nder present law, corporations operating a trade or

business in a possession of the United States are

entitled to exclude from gross income all income from

sources without the United States, including foreign

source income earned outside of the possession in which

they conduct business operations, if they meet two

conditions. 

H.R. Rep. No. 94-658 at 253-54 (emphasis added); see also S. Rep.

No. 94-938 at 277. With this in mind, a new provision, 26 U.S.C.

§ 936, was added "for the tax treatment of U.S. corporations

operating in Puerto Rico." H.R. Rep. No. 94-658 at 256 (emphasis

added); see also S. Rep. No. 94-938 at 279. We think this

language supports the Commissioner's view that the taxpayer must be

the one actively conducting the trade or business. 
-26-

As to the changes in the possessions tax credit

legislation, Congress stated that it sought to "assist the U.S.

possessions in obtaining employment-producing investments by U.S.

corporations, while at the same time encouraging those corporations

to bring back to the United States the earnings from these

investments to the extent they cannot be reinvested productively in

the possession." H.R. Rep. No. 94-658 at 255; see also S. Rep. No.

94-938 at 279 (using the same language). The congressional history

reflects a dual intention to stimulate investment, both active and

passive, in Puerto Rico and to encourage the growth of new jobs in

Puerto Rico. H.R. Rep. No. 94-658 at 255; S. Rep. No. 94-938 at

279 (same). Those are related but not identical objectives.

Congress's emphasis on the creation of new jobs by operating

companies is also reflected by the fact that Congress mandated that

the Department of the Treasury report to it periodically on the

progress in meeting that goal. See H.R. Rep. No. 94-658 at 259

(stating that the Department of the Treasury's reports are to

include, among other things, "an analysis of . . . the

[provision's] effects on investment and employment in the

possessions"); S. Rep. No. 94-938 at 282 (same).

Although the Department of the Treasury has not

promulgated regulations under § 936(a), its reports provide data

both on how Treasury has interpreted that section and on the

context of the legislation. We look, in particular, to Treasury's

1989 Report. See The Operation and Effect of the Possessions

Corporation System of Taxation, supra. The 1989 Report provides
-27-

insight into Treasury's interpretation of § 936. For example, the

1989 Report says "[b]y enacting section 936, Congress sought to

assist Puerto Rico in obtaining employment-producing investments."

Id. at 3; see also id. at 46 (same). Accordingly, Treasury matched

"possessions corporations' U.S. income tax returns with payroll and

employment data from the companies' federal unemployment insurance

tax returns" to determine "whether this objective has been

attained." Id. at 46. In particular, Treasury sought to measure

the "direct employment associated with section 936 companies." Id.

For example, as of 1989, Puerto Rican business expansion

had "been concentrated in four high-technology industries:

chemicals (including pharmaceuticals), scientific instruments,

electrical and electronic equipment, and machinery." Id. at 27.

From 1970 to 1988, the chemical industry's earned income grew from

11% to 44% of total income originating in Puerto Rican

manufacturing. Id. Nearly all of the investments in those

industries were made by possessions corporations. Id. at 27-29.

Indeed, in 1983, about 62% of the employees in the Puerto Rican

manufacturing sector were employed by possessions corporations;

this represents about 12% of Puerto Rico's total employment. Id.

at 3. As the 1989 Treasury Department Report makes clear, most of

the corporations that qualified to receive the possessions tax

credit were manufacturing corporations. Id. at 31. 

On the whole, the views on eligibility for the tax credit

expressed both in the legislative history and in the Treasury

Department's Report are more consistent with those of the
-28-

Commissioner and the Tax Court than those of M-PR. Those views are

not binding on us, but they have some weight. Both sources tend to

support the Commissioner's view that § 936(a) requires that the

taxpayer itself actively conduct a trade or business, with the

expectation being that this active conduct by the taxpayer would

increase employment and investment in Puerto Rico. Both sources

contemplate that the taxpayer be the party employing workers in the

Puerto Rican economy. 

Here, the Tax Court's conclusion, which was not clearly

erroneous, was that M-PR's investment in Puerto Rico's economy was

virtually nonexistent. MedChem, 116 T.C. at 337. M-PR's

activities in Puerto Rico "failed even to qualify as a trade or

business in Puerto Rico," id. at 338, much less as an actively

conducted one. A-PR and M-USA directed and controlled "[a]ll of

the business activities connected to Avitene." Id. Furthermore,

during the relevant three-year period, M-PR placed only one

employee in Puerto Rico. That employee, Mr. Perez, worked for M-PR

out of a one-room office for less than one year of the requisite

three-year period.

2. Western Hemisphere Trade Corporations

M-PR urges that we follow the construction that some

courts have given to the phrase "active conduct of a trade or

business" under the Western Hemisphere Trade Corporation ("WHTC")

provisions of the Internal Revenue Code of 1954, § 921, 68A Stat.

at 290, that were repealed in 1976. Section 921 defined "Western

Hemisphere trade corporation" to mean "a domestic corporation all
-29-

of whose business . . . is done in any . . . countries in North,

Central, or South America, or in the West Indies, and which

satisfies" two requirements. Id. One requirement was that at

least 95% of the corporation's gross income for the three preceding

years be derived from sources outside of the United States. Id.

The other was that at least 90% of the corporation's gross income

for the three preceding years be "derived from the active conduct

of a trade or business." Id. 

Although at first cut the WHTC provision appears to be an

apt point of comparison, ultimately this analogy does not assist MPR. This is primarily because of the important differences between

the purposes of the WHTC provision and § 936. 

Congress may, particularly in the internal revenue code,

use the same phrase, such as "active conduct of a trade or

business," in attempts to reach different ends. The Supreme Court

made this point in Commissioner v. Groetzinger, 480 U.S. 23 (1987).

After noting that the phrase "trade or business" appeared in over

fifty sections of the Code, the Court stated: "[I]n this opinion

our interpretation of the phrase 'trade or business' is confined to

the specific sections of the Code at issue here. We do not purport

to construe the phrase where it appears in other places." Id. at

27 & n.8. Other circuits construing the phrase "trade or business"

have also concluded that the phrase has different meanings in

different sections of the Internal Revenue Code. In Hughes v.

Commissioner, 38 F.2d 755 (10th Cir. 1930), for example, the Tenth

Circuit, construing the statutory phrase "trade or business" in
-30-

section 204(a) of the Revenue Act of 1921, Pub. L. No. 67-98,

§ 204(a), 42 Stat. 227, 231 (1921), stated that "[w]e are here

concerned only with the meaning of this phrase as used in this

section. The same phrase, in other statutes, or in other sections,

in a different context, and for a different purpose, may or may not

be helpful." Hughes, 38 F.2d at 757. This is not to say that the

WHTC provision is necessarily inapposite, but rather simply to

emphasize, as we have emphasized in other contexts, that "the same

words may play different roles in different contexts." Walker v.

Exeter, 284 F.3d 42, 45 n.4 (1st Cir. 2002). The relevance of the

WHTC provision, then, turns on its similarity to the provision at

issue here. 

The Tax Court has described the legislative history of

the WHTC provision as disclosing a congressional "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."

Kewanee Oil Co. v. Comm'r, 62 T.C. 728, 737 (1974). Accordingly,

[i]t 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 corporations of other

countries.

Id. at 737-38.

Like the WHTC provision, the possessions tax credit was

meant to offset the competitive disadvantage suffered by American
-31-

companies. The possessions tax credit, however, was meant not only

to offset certain impediments for U.S. corporations investing in

Puerto Rico, but also to increase investment and employmentproducing opportunities in Puerto Rico. This is a difference that

makes a difference. To the extent that the WHTC provision was

meant to increase the foreign competitiveness of domestic

corporations, the geographic location of those corporations'

operations was relevant only to a limited extent -- that is, it was

important only to ensure that the domestic corporation actually

engaged in some foreign commerce. In contrast, the possessions tax

credit was meant, in addition to advancing the competitiveness of

domestic corporations, to stimulate investment in particular

places, including Puerto Rico. On this account, unlike the WHTC

provision, the location of the corporation's trade or business was

critical to advancing this goal. After all, the goal is promoting

investment in the possessions -- a goal the attainment of which is

intrinsically tied to the location of the investments made. 

M-PR relies on Frank v. International Canadian Corp., 308

F.2d 520 (9th Cir. 1962), a Ninth Circuit decision applying the

WHTC provision of section 109 of the Internal Revenue Code of 1939.

It is far from clear that this court would have viewed Frank's

facts the same way and reached the same outcome as did the Ninth

Circuit, even under the WHTC. 

In Frank, the Pennsylvania Salt Manufacturing Corporation

of Washington, a domestic corporation that regularly conducted

business activities in British Columbia, decided to assume new
-32-

shipping responsibilities. Id. at 522-23. For legitimate business

reasons having to do with the most favored nation clauses in its

contracts and the Robinson-Patman Act's prohibitions, Washington

decided to form a new corporation, named International Canadian

Corporation, as a WHTC, in order to perform the shipping. Id.

International, in turn, had one full-time employee and assumed the

parent's sales functions. Id. International did utilize services

of Washington's employees and paid for those services. Id. at 523.

The Ninth Circuit held, on review of a district court decision,

that International, which came into existence for legitimate

business reasons unrelated to the WHTC provision, was not

disqualified from the WHTC credit although it had assumed former

business of Washington, utilized and paid for help from

Washington's employees, and did not have a source of supply or

customers independent of Washington's. Id. at 526-27. The court

found that International clearly was active, earning its income by

performing a variety of services relating to the sale of chemical

products. Id. at 525-27. 

The Ninth Circuit's opinion is of limited utility because

of the factual distinctions between it and the case here. For

example, Frank found that International's existence was justified

by a legitimate business purpose. Id. at 526. At least from early

1990, when M-USA had decided not to build a manufacturing plant in

Puerto Rico, it is difficult to view M-PR as anything other than a

corporate shell with little business reason to exist other than to

attempt to secure the § 936 credit. Furthermore, as already
11 The sections selected by the Tax Court concern the

following matters:

(1) 26 U.S.C. § 179 (2000). Section 179 deals with the election

to expense certain depreciable business assets. It states, in

part, that "[a] taxpayer may elect to treat the cost of any

section 179 property as an expense which is not chargeable to

capital account." Id. § 179(a). It defines "Section 179

property," for purposes of § 179, as "any tangible property

(to which section 168 applies) which is section 1245 property

(as defined in section 1245(a)(3)) and which is acquired by

purchase for use in the active conduct of a trade or

business." Id. § 179(d)(1) (emphasis added). 

(2) 26 U.S.C. § 355 (2000). Section 355 deals with the

distribution of stock and securities of a controlled

corporation. Section 355(a)'s provisions apply 

only if either -- (A) the distributing corporation, and

the controlled corporation . . . is engaged immediately

after the distribution in the active conduct of a trade

or business, or (B) immediately before the distribution,

the distributing corporation had no assets other than

stock or securities in the controlled corporations and

each of the controlled corporations is engaged

immediately after the distribution in the active conduct

of a trade or business.

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discussed, the divergent policy goals of the possessions tax credit

and the WHTC provision mean that the analogy is strained from the

start. Nothing in the history of the WHTC leads us to the

taxpayer's interpretation.

E. Analogy to Other Regulatory Definitions

The Tax Court found twenty-two uses of the phrase "active

conduct of a trade or business" in the Internal Revenue Code.

MedChem, 116 T.C. at 330 & n.13. M-PR argues that the Tax Court

erred in looking by analogy to regulations interpreting "active

conduct of a trade or business" as used in 26 U.S.C. §§ 179, 355,

and 367, for purposes of interpreting the phrase as used in § 936.11
Id. § 355(b)(1) (emphases added).

(3) 26 U.S.C. § 367 (2000). Section 367 deals with foreign

corporations. It provides that, if in connection with certain

defined exchanges, United States persons transfer property to

foreign corporations, "such foreign corporation shall not, for

purposes of determining the extent to which gain shall be

recognized on such transfer, be considered to be a

corporation." Id. § 367(a)(1). But, in general, § 367(a)(1)

does "not apply to any property transferred to a foreign

corporation for use by such foreign corporation in the active

conduct of a trade or business outside of the United States."

Id. § 367(a)(3)(A) (emphasis added). 

-34-

The argument is that the purposes of those sections are so

different from the purpose of § 936 that their selection was

arbitrary.

We do not think the selection was arbitrary. We analyze

one example to demonstrate our point. M-PR says the regulation

under § 179 is not analogous because that regulation is explicit:

it refers to a trade or business "actively conducted by the

taxpayer." 26 C.F.R. § 1.179-2(c)(6) (2001) (emphasis added). It

states, in part, that "a taxpayer generally is considered to

actively conduct a trade or business if the taxpayer meaningfully

participates in the management or operations of the trade or

business. A mere passive investor in a trade or business does not

actively conduct the trade or business." Id. As stated earlier,

our view is that the "by the taxpayer" requirement is implicit in

§ 936, and so the analogy to 26 C.F.R. § 1.179-2(c)(6) is not

strained. 

M-PR argues that the more appropriate analogy is to 26

U.S.C. § 936(h)(5), and guidance provided thereunder, which, M-PR
-35-

says, contemplates the use of contract manufacturers. That section

states, in relevant part, that 

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 . . . 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.

26 U.S.C. § 936(h)(5). Section 954(d)(1)(A) states that 

the term "foreign base company sales income" means income

. . . 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.

26 U.S.C. § 954(d)(1) (2000). M-PR says that it relied on a

Revenue Ruling concluding that, under § 954, when a "controlled

foreign corporation" contracts out a manufacturing process to

another manufacturer, the contract manufacturer's performance is

considered to be performance by the controlled foreign corporation.

See Rev. Rul. 75-7, 1975-1 C.B. 244. M-PR says § 936(a)(2) must be

read, in light of Revenue Ruling 75-7, not to require the taxpayer

actually to supervise the contract manufacturer's activities.

The two sections, however, measure different things. As

the Commissioner points out, the Revenue Ruling allows contract

manufacturing to be taken into account in narrow situations, not

present here. Section 936(h)(1) taxes "intangible property income"
12 The taxpayer relies on cases arising under other

provisions of the Internal Revenue Code, which hold that a taxpayer

need not manufacture its own product but may be a manufacturer by

use of a contract manufacturer. See Suzy's Zoo v. Comm'r, 273 F.3d

875, 879 (9th Cir. 2001); Polaroid Corp. v. United States, 235 F.2d

276, 278 (1st Cir. 1956). Those cases address different problems.

One size does not fit all.

-36-

to the U.S. shareholder of the § 936 corporation unless the § 936

corporation elects either the cost sharing or profit split method.

See 26 U.S.C. § 936(h)(5)(C). To make that election, the § 936

corporation must have a "significant business presence" ("SBP") in

the possession as to that product or service. In order to show a

"significant business presence" certain numerical tests must be met

and, in addition, the product must be manufactured or produced in

the possession within the meaning of § 954(d)(1)(A). For these

stated purposes, contract manufacturing costs may be attributed to

the taxpayer as allowed by the regulations. Those regulations, for

purposes of the SBP requirement, permit a possessions corporation

to treat the cost of contract manufacturing as a cost of direct

labor. See 26 C.F.R. § 1.936-5(c). The purpose appears to be to

permit a taxpayer who has already satisfied the 75% "active conduct

of a trade or business" requirement then to obtain § 936 credit for

the contract manufactured product. We reject the argument that the

section 936(h)(5) provisions govern by analogy the initial question

of what is meant by the active conduct of a trade or business.12

F. Application of Section 936(a) to the Facts

Under our understanding of the statutory term, the

requisite gross income of M-PR, over the relevant three-year time
-37-

period, was not "derived from the active conduct of a trade or

business within a possession of the United States." 26 U.S.C. §

936(a)(2)(B). This is because M-PR was not engaged in the active

conduct of a trade or business in Puerto Rico for the three

preceding years. The Tax Court was "not even able to find that

MedChem P.R. had any meaningful business activity in Puerto Rico."

MedChem, 116 T.C. at 337. We agree that, whatever M-PR's presence

in Puerto Rico, over the relevant time-period, it did not actively

conduct a trade or business there. A-PR and M-USA, but not M-PR,

directed and controlled all of the Avitene business activities. APR performed the tasks required in the manufacturing process,

without the ability of M-PR to control any part of that process.

During much of the relevant three-year period, M-PR had

no employees. Its one employee, Mr. Perez, was a former A-PR

employee who worked out of a one-room office maintained by M-PR.

He worked for M-PR from March 1988 to June 1990, though only about

ten months of his employment occurred during the relevant threeyear period. M-PR argues that, for other reasons, A-PR activities

must be attributed to M-PR, and that A-PR employees are M-PR's

employees. The Tax Court adopted as its definition of an employee

of M-PR the definition used by the IRS to determine if an

individual is an employee for payroll tax and withholding purposes.

See MedChem, 116 T.C. at 341-43 (citing 26 C.F.R. § 31.3401(c)-1(b)

(stating, among other things, that "if an individual is subject to

the control or direction of another merely as to the result to be

accomplished by the work and not as to the means and methods for
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accomplishing the result, he is not an employee")). Under that

approach, neither A-PR nor the contract employees meet the test.

Nor do those M-USA employees who served as M-PR officers but

received no compensation from M-PR. We think the Tax Court's

approach was correct because we agree that none of the purported MPR employees were subject to M-PR's control as to the means and

methods of carrying out the production and sale of Avitene. Even

were this not the case, we also think it significant that, until

this litigation, M-PR consistently treated these individuals as

nonemployees for tax purposes. 

Finally, M-PR makes a policy argument that it should be

within the scope of the tax credit because it created jobs in the

sense that it could have chosen earlier to move the Avitene

production process out of Puerto Rico. Had it done so, there would

have been a net job loss. But avoiding the destruction of jobs is

not the same as creating new job opportunities, which was part of

Congress's concern. It would seem contrary to congressional intent

to create incentives for American companies to threaten the loss of

contract manufacturing jobs in Puerto Rico unless the American

companies were given the possessions tax credit. More

significantly, M-PR's argument is too broad. All investment, of

whatever nature, in Puerto Rico may be thought to contribute to job

producing opportunities. But Congress did not intend the credit to

apply whatever the nature of the investment. Congress limited the

credit to those involved in the "active conduct of a trade or

business." And that does not describe what the taxpayer here did.
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G. Conclusion

We have no basis, in the statute or on the facts, to

upset the Tax Court's reasonable conclusion that the taxpayers owe

the deficiency assessed. This case has not required us to evaluate

the Tax Court's proposed rule; each case will bring factual

variations, which bring with them legal consequences.

We affirm the judgment of the Tax Court.