# Un ited S tates Co urt o f Ap pea ls 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 .

____________________ DavidA. 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 Di vision , 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 immediatelypreceding the close of the tax year must be "derived fromsources 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. -2-

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 t hat 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 bu siness 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 andthe 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 Rev enue Act o f 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 phas edout. See 26 U.S.C. § 936(j). This case has, in the interim, consequences for domestic corporations involved in2 Puerto Rico is a Commonwea lth; 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 Rico 2 and certain other posses sion s. Unfortunately, there are no promulgated regulations under § 936(a) anddomestic corporations have been forced to make business arrangements in U. S. p ossessions without the prior guidance such regulations might provide.

Basedprimarily on § 936 's t ext, understood in the context of the legislative history , we c onclude that M-PR has failedto meet the "active conduct of a trade or business" requirement and, accordingly, we affirm the Tax Court's judgment. We do s o without adopting the Tax Court's proposed test for what constitut es the active conduct of a trade or business in a U. S . possession for purposes of § 936(a). I. The facts in t his 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. changedits name to BioChem Products, Inc. Then,

on March 1, 1992, BioChem Products, Inc. changed its state of3 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 deficiencyoccurred 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 defi cien cy was $815,196. MedChem , 116 T.C. at 309. In contrast, both parties, at v ariou s points in their briefs, state that the sum is $815,916. The Notice of Defi ciency uses both figures. We assume that $815,196 is the correct figure. -4- incorporation to Massachusetts and, on November 25, 1992, changed its name to MedChem P.R., Inc. M-PR andall 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 $815,196 4 in M-PR's federal income tax paid for the tax year ending August 31, 1992, and a deficiencyof $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--5-

clotting drug manufacturedby 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 soldthe equipment, raw materials, technology, and other assets associatedwith Avitene's manufact uring. 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 andequipment 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 Avi tene. M-USA had nothing to do with the drug. Until te n day s prior to the acquisition, M-PR did not exist. As part of the sale, A-PRagreed to continue manufacturing Avitene for M-PR using A-PR's own facility and labor and M-PR's recently-acquired raw materials andequipment. A-PR also used the technology acquired by M-USA. M-PRheld title to the in-process and finished Avitene. A-PR shippedfinished Avitene from its facility to M-USA, and title passedto 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-6-

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 rea s on 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 steadysupply of Avitene until it built its own man ufactu ring 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 empl oyees. Its one employee, Mr. Perez, was a former A -P R employee. He worked for M-PR from March 1988 to June 1990 out of

a one-room office that M-PR mainta ined. Mr. Perez spent much of his time planning M-PR's tra nsition to its own Avitene

man ufacturing facility. M-PR also paid three independen t contractors to assist Mr. Perez. M-PR treated the independent

co ntract ors as nonemployees for payroll and tax purposes. M-USA andA-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 MUSAhad hoped to establish their own manufacturing facility in Puerto Rico. M-PRpurchase d land in Puerto Rico, on which it plannedto 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 facilityin Puerto Rico. M-PR then wrote off its capital expenditures that had been made on the new facility andclosed itsPuerto 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-PRchecks 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 fa cilityin Woburn. Significant elements of the equipment we r e movedfrom 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 ha d subs tantially 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) req uire s. 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-8-

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, andactively 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 onlyto the extent that the performance of those services is adequately supervisedby 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 mainlandU.S. facility) performed, directed, and controlledall 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 H umacao fa cility. 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, andsold the drug in the UnitedStates. Id. at 339. Indeed, the processing agr eeme nt prohibitedM-PR fromtaking 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, andperformance of any of M-PR's obligations, arising from the5 Hadthe Treasury Department promulgated a regulation

interpreting § 936(a), we would have been requ ired, 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 c ivil actio ns tried without a jury." 26 U.S.C. § 7482(a)(1) (2000); see also Silverman v. C omm'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 revi ew its f actual findin gs , 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 arg ument with respect to the Tax Court's factual findings , w e reject the argument.

There are no Treasury Department regulations interpreting § 936(a), 5 nor is the term "active conduct of a trade or business" definedfor purposes of § 936. There are, however, some guides to6 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 statedthat 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. 28 1, 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] fairlyshould be." White , 305 U.S. at 292. M-PR's argument would be more appropriate were this a case involving a statute imposing -10- statutoryinterpretation, 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 taxp ayer b ears 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. He lvering , 292 U.S. 435, 440 (1934); Norfolk S. Corp . v . Comm'r , 104 T.C. 1 3, 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") . 6a tax, rather than a statute permitting a tax credit. -11- B. Positions of the Parties

The parties have presented the cour t 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 t he taxpayer "participates regularly,

c ontinually, extensively, and actively in the manageme nt an d operation of its profit-motiv a ted 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 und er i ts-12-

newlycrafted 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 andmana geme nt of the contract manufacturer. The Commissioner seeks affirmance of the Tax Court's result, but at oral argument protestedthe Tax Court's test, which is more beneficial to ta xpayers than the IRS's proposed test for what constitutes t h e active conduct of a trade of business. The IRS proposes t ha t outsourcedmanufacturing may never (well, hardly ever) qualify for the tax credit. Only in rare i nstances, 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 t he statute's plain meaning does not preclude tax credits to taxpayers who use contract manufacturers located in the possessions andthat, if more were required, it has, on the facts, provided the requisite

more. M-P Rsays the Tax Court is wrong in its statutory interpretation and in its choice o f tes t. 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-13-

meaning argume nts, look to the Act's legislative history for further guidance regarding congressional intent in enacting § 936, andcompare the section at issue with the now-repealed Western Hemisphere Trade Corporation provisions of the I nternal 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

Be fore analyzing the statute, we think it helpful to

u nderstandthe context in which the statutory interpre tatio n 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 andqualified pass ive 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 sect ion 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, o ffs et dividends received from a wholly owned 936 subsidiarywith a 100 percent dividends-received-14- 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 b oth subparagraph (A) andsubparagraph (B) of paragraph (2) are sati sfied , there shall be allowed a s a credit against the tax imposedby 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 su ch t axable 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-15-

income. 26 U.S.C. § 936(h). The Treasury Department has issue d 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 tra de or business" language that is at issue here. 26 U.S.C. § 936(a)(2)(B).

M-PRargues 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, th at t he taxpayer corporation need only derive its income f romsome nonpassive source, meaning that the taxpayer can qualify by deriving its incom e from the active conduct of a third party rather than fromthe taxpayer's own ac tive c onduct. 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, wou ld qua lify 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 fromthe active conduct of a trade or business" to m ean income "derivedfrom an active, r athe r 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 the7 M-PRnotes that the Commissioner has previously taken the

position that the "active conduct" requirement i s me ant to distinguish be twee n investment income and business income. That proposition is different from the proposition M-PRurges here, which is that the "act ive c onduct" requirement is met so long as the taxpayer derives income from any source not wholly passive. To saythat the "active conduct" requirement distinguishes investment income from business income is not to say that all income other than investment income meets the requirement. -16- credit. 7 We accept the Commissione r's vi ew 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 12 48226, 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 busi ness 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-17-

the term relates to a business, it is defined as "[t]he action or

manner of conducting, directing, managing, or ca rryi ng 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 ThirdNew International Dictionary of the English Language Unabridged473 (P.B. Gove et al. eds. 1993). "Active," in turn, is generallydefined as "[c]haracterizedby action" and is defined in terms such as "[o]riginating or communicating action," "practical," "working, effective, having practical operation or results." Ox fordEnglish 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 mea ning ful business activity in Puerto Rico." MedChem , 116 T.C. at 337. It found that M-PR's "involvement in Pu erto Rico during the 3-year period failed even to qualify as a-18-

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 everytask required in the m anuf acturing process," without the ability of M-PR "to manage, direct, or con trol any part of the manufacturing pro cess," 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 attributedto M-PR for the purposes of § 936(a). The answer to this question hinges on M-PR's second claim, that the statutoryphrase requires only tha t the income "derived" by the taxpayer be from some thirdparty 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 t h e statutoryrequirement that at least 75% of th e t axpayer's gross income during the relevant period be "derivedfrom the active conduct of a trade or business within a po ssess ion of the United States." 26 U.S.C. § 936(a)(2)(B). M-PR correctly notes that C ongress could have more explicitly said, "the active cond uct b y 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 referen ced 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. Ambiguityin 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 bu rden of p roving entitlement to the § 936 credit claimed. To read the statute as requiring only that the income be derivedfrom a third party's active conduct would eli min ate the distinction between active conduct income and all other income, including pas siv e investment income. Virtually all passive investment income, for example, is der ived , 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 197 6 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 R ico (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 c onduct 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 rel eva nt 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 appearedin 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 exempteda domestic corpor atio n from federal taxes on foreignsource income if, for the three years prece ding the close of the taxable year, it derived at least 80% of its gross inc ome from8 The 1954 Internal Reven ue Code provided, in relevant

part: Sec. 931. Income FromSources Within Possessions of the

United States. (a) General Rule. -- In the case of citizens of the UnitedStates or domestic corporations, gross income means only gross income fromsources within the United States if the conditions of both paragraph (1) and paragraph (2) are satisfied: -21- sources within a possess ion and 50% or more of its gross income "fromthe active conduct of a trade or business" within the possessions. § 262, 42 Stat. at 271 . Congress enacte d t his 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 exe mption into section 931 of the Internal Revenue Code of 1954. See In terna l 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, th at 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 ci tizen or domestic corporation (computed without the benefit of this section) for the 3-year period immediately preceding the close of the taxable year . . . was derivedfrom sources within a posses sion 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 p eriod. . . was derived from the ac tiv e 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 secti on 931. The then-existing provision -- 26 U.S.C. § 931 -- was retained, but onlyfor qualifying "individual citizens," as opposed to corporations. In addition, it was made inapplicable to Puerto Rico b y defi ning "possession," for purposes of section 931, not to include Puerto Rico. § 1051(c), 90 Stat. at 1645. In the case of domestic corpor a tions 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 avai lable . 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- remainedin 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 ReformAct 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 legislation10 Since 1976, there have b een many amendments to the

possessions corporations taxation system in general and to § 936 in particular, in cludin g those imposed by the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324 (1982), and bythe 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 unchangedsince 1976, except that its 50% "trade or busine ss" requirement is now a 75% requirement. -23- effecteda number of revisions in prior law. To focus on the

re visio n central to this case, the new § 936 transformed the old section 931 exemption mechanism into a tax credit . The credit permits domest ic c orporations to offset U.S. taxes on income "derivedfrom 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 Departmen t'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 establishedplants 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 exem ptio n argued that the possessions corporation system of taxation was needed to offset the U.S. minimumwage requirement, the requirement to use U.S. flag vessels in transp ort ing goods to the United States, and other Federally imposed requirements that tended to reduce Puerto Rico's ability to com pete 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 trad e or b usiness 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 i n vested in foreign capital markets and to hasten their repatriation if not used in the possession. . . . To continue promoting Puerto Rico's industrial d evelopment, the Tax Reform Act of 1976 therefore lef t int act the exemption for income derived by U.S .-24- corporations from operations in a poss essi on. It also exemptedfrom 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 T reas ury Report described the effect of the change:

Change in the scope of and method of effecting the tax exemption . Before 197 6, 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 s ale 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 h as i ts trade or business and which is attributable to the in vest ment of funds derived from such trade or business for use within the possession. Rather than exempt ing t he income from U.S. taxation, section 936 provides a credit equal to (and, therefore, fullyoffsetti ng) the U.S. tax on the income. The section 936 credit is not availabl e fo r other income earnedby a possessions corporation. However, a regular foreign tax credit may be claimed for foreign (including possession) taxes paidor 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 corpora tio ns conducting trade or business in possessions of the U.S. as well as issues arising under the now-repealed Western Hemisphere Trad e Corporation provisions of the Inte rnal Revenue Code of 1954, §§ 921-922, 68AStat. 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, cor pora tions operating a trade or

business in a possession of the United States are entitledto exclude from gross income all income from sources without the United States, including foreign source income earned outside of the possession in which theyconduct business op eratio ns, 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); se e 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 sta tedthat 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 Ric o. H.R. Rep. No. 94-658 at 255; S. Rep. No. 94-938 at 279 (same). Those are related but not identical objec tiv es. Congress's emp has is 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 Dep artmen t of the Treasury's reports are to include, among other things, "an analysis of . . . the [provision's] effects on inve stme nt and employment in the possessions"); S. Rep. No. 94-938 at 282 (same).

Although t he D epartment of the Treasury has not promulgatedregulations under § 93 6(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 Corp oratio n System of Taxation , supra . The 1989 Report provides-27-

insight into Treasury's interpretation of § 936. For example, the 1989 Report says "[b]y en act ing 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 thi s ob jective has been attained." Id. at 46. In particular, Treasury sought to measure the "direct employment associatedwith 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 equipm ent, and machinery." Id. at 27. From1970 to 1988, the chemical industry's earned income grew from 11% to 44% of total inco me originating in Puerto Rican manufacturing. Id. Nearly all of the investments in those i ndustries were made by possessions corporations. Id. at 27-29 . Indeed, in 1 983, 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 t hat qualified to receive the possessions tax credit were manufacturing corporations. Id. at 31.

On the whole, the views on eligibility for the tax credit expressedboth in the legislative h istory 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 thi s acti ve conduct by the taxpayer would increase employment and investment in Pu erto 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 virtuallynonexistent. M edC hem , 116 T.C. at 337. M-PR's activitie s in Puert o Rico "failed even to qualify as a trade or business in Puer to R ico," id. at 338, much less as an actively conductedone. 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-PRurges tha t 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 sour ces o utside 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 o f 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 fiftysections 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" h ave al so 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-

sec tion 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

conc ernedonly 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 sim ply 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.

Th e Ta x 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 compet itors 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 thre at o f foreign competition, one might well conclude that in passing the Western Hemisphere provisions Congress intended to gra nt rel ief to United States business activityin the Americas only to the extent that the beneficiary corporation conducted active business operations abroad vulnerable to the competitive threat posedby 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 off set certain impediments for U.S. corporations investing in Puerto Rico, but also to increase investment and emplo ymen tproducing opportunities in Puerto Rico. This is a difference that makes a difference. To the exte nt that the WHTC provision was meant to increase the foreign competitiveness of do mest ic 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 engagedin 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-PRrelies on Frankv. International Canadian Corp. , 308 F.2d520 (9th Cir. 1962), a Ninth Circuit decision applying the WHTC provision of section 109 of the Internal Revenue Code of 1939 . It i s fa r 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 W ashington, a domestic corporation that regularly conduct e d business act ivit ies in British Columbia, decided to assume new-32-

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

re asons having to do with the most favored nation clauses in its contracts and the Robinson-Patman Act's prohibitions, Washington decidedto form a new corporation, named International Canadian Corporation, as a WHTC, in o rder to perform the shipping. Id. International, in turn, hadone 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 Internati onal, which came into existence for legitimate business reasons unrelated to the WHTC provision, was not disqualifiedfrom the WH TC 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 foundthat 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, Frankfound that International's existence was justified by a legitimate business purpose. Id. at 526. At least from early 1990, when M-USA haddecided 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 already11 The se ctions 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 c ost o f any section 179 property as an expense which is not chargeable to capital account." Id. § 179(a). It defines "Section 179 pr operty," for purposes of § 179, as "any tangible pro pert y (to which section 168 applies) which is section 1245 property (as defined in sec tion 1 245(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 o f st ock 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 dist r ibuting corporation had no assets other than stock or securities in the controlled co rpor ations and each of the controlled corporations is engaged immediatelyafter the distribution in the active conduct of a trade or business . -33- 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 erredin looking by analogy to regulations interpreting "active conduct of a trade or business" as used in 26 U.S.C. §§ 179, 355, and367, for purposes of interpreting the phrase as used in § 936. 11Id. § 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 definedexchanges, United States persons transfer property to foreign corporations, "such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognizedon 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 for eign corporation for use bysuch 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 conside red to actively conduct a trade or business if the taxpayer meaningfully participates in the management or ope rations 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-PRargues 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 treatedas having a significant business presence in a possession with respect to a product producedin whole or in part by the electing corporation in the possession . . . unless such product is manufacturedor 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 per son and its sale to any person, th e sale of personal property to any person on behalf of a related person, the pu rcha se of personal property from any person an d 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 soldon 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 " con trolled foreign corporation" co ntracts out a manufacturing process to another manufacturer, the contract manufacturer's performance is consideredto 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

m anufacturing to be taken into account in narrow situation s, no t 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 statedpurposes, 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 o f 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 satisfiedthe 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 unde rstand ing of the statutory term, the requisite gross income of M-PR, over the relevant three-year time-37-

period, was not "derived from the acti ve conduct of a trade or bu sines s 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 MedChemP.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, directedand controlled all of the Avitene business activities. APRperformed 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. Per ez, 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 t en months of his employment occurred during the relevant three

year 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 IR S 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 accomplishedby the work and not as to the means and methods for-38-

accomplishing the result, he is not an employee")). Under that ap proach , neither A-PR nor the contract employees meet the test. Nor do those M-USA employees who served as M-PR officers but receivedno compensation from M-PR. We think the Tax Court's approach was correct because we agree that none of the purported MPRemp loyees wer e 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 significa nt th at, until this litigation, M-PR consistently trea t ed 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 wouldseem contrary to congressional intent to create incentives for American companies to threaten the loss of contract manufacturing jobs in Puerto Rico unless the American

com panies were given the possessions tax credit. Mo r e significantly, M-PR's argu ment i s 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 applywhatever the nature of the investment. Congress limited the credit to those involved in the "ac tive cond uct of a trade or business." And that does not describe what the taxpayer here did.-39-

G. Conclusion

We hav e 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.