United States Court of Appeals

For the First Circuit

No. 13-1008

OMJ PHARMACEUTICALS, INC.,

Plaintiff, Appellant,

v.

UNITED STATES OF AMERICA,

Defendant, Appellee.

APPEAL FROM THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF PUERTO RICO

[Hon. Gustavo A. Gelpí, U.S. District Judge]

Before

Torruella, Lipez, and Kayatta,

Circuit Judges.

William L. Goldman, with whom Robin L. Greenhouse, Nathaniel

J. Dorfman, McDermott Will & Emery LLP, Jerome A. Swindell,

Assistant General Counsel, and Johnson & Johnson were on brief, for

appellant.

Teresa E. McLaughlin, Attorney, Tax Division, with whom

Bethany B. Hauser, Attorney, Tax Division, and Kathryn Keneally,

Assistant Attorney General, were on brief, for appellee.

June 3, 2014
KAYATTA, Circuit Judge. From 1976 until 1996, section

936 of the Internal Revenue Code made available to U.S.

corporations a tax credit fully offsetting the federal tax owed on

income earned in the operation of any trade or business in Puerto

Rico. In 1996, Congress enacted the Small Business Job Protection

Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755, setting in motion

the complete repeal of section 936, ameliorated by a ten-year

transition period during which the credit remained available only

to taxpayers who had claimed it in previous years. During the

final eight years of that transition period, the taxable income

that an eligible claimant could take into account in computing its

credit was capped at an amount roughly equal to the average of the

amounts it had claimed in previous years. Though the cap was

generally fixed, it could be adjusted up or down to account for a

taxpayer's purchases and sales of businesses that had themselves

generated credit-eligible income. Thus, as the parties agree, if

one U.S. corporation sold to a second U.S. corporation a business

that accounted for $1 million in average prior year credit claims,

the credit cap for the purchasing corporation would normally

increase by $1 million, and the credit cap for the selling

corporation would normally drop by the same amount.

This appeal requires us to decide, in a case of first

impression, the effect on a U.S. taxpayer's credit cap of a sale of

a line of business in Puerto Rico to a foreign corporation that

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does not pay U.S. corporate income taxes. Having made three such

sales, appellant OMJ Pharmaceuticals, Inc. ("OMJ"), argues that it

was not required to reduce its cap by the amount of credit-eligible

income associated with the lines of business sold because the

buyer, as a foreign corporation, had no credit cap to increase or

even establish. The government disagrees, arguing that regardless

of whether the purchaser of a line of business could increase or

establish a credit cap, a seller was required to reduce its own cap

by the amount associated with the line of business. On crossmotions for summary judgment, the district court sided with the

government, rejecting OMJ's claim for a tax refund of approximately

$53 million. Because we read the controlling provisions of the

Internal Revenue Code to require otherwise, we reverse and remand

with instructions to enter summary judgment in OMJ's favor.

I. Background

A. The Puerto Rico and Possessions Tax Credit

Between 1976 and 1996, Congress encouraged U.S.

corporations to invest in Puerto Rico and other U.S. territories by

establishing a possessions corporation system of taxation. 

Congress implemented that system primarily by creating the "Puerto

Rico and possession tax credit," codified in section 936 of the

Internal Revenue Code. See generally Dep't of the Treasury, The

Operation and the Effect of the Possessions Corporation System of

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Taxation, Sixth Report (1989). As described by the Treasury

Department:

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

deduction, which frees the dividend income from federal

tax.

Id. at 5.

In 1996, Congress amended section 936 to terminate the

credit, subject to certain transition rules. Small Business Job

Protection Act of 1996, Pub. L. No. 104-188, § 1601, 110 Stat.

1755, 1827, 26 U.S.C § 936 (amended 2007). Under the transition

rules, an existing credit claimant--that is, a taxpayer who

previously claimed the credit, § 936(j)(9)--could continue to claim

the credit for up to ten years, § 936(j)(3). Beginning in the 1998

tax year, however, the amount of the credit became subject to a cap

roughly equal to the annual average of a claimant's inflationadjusted possession income for the five taxable years immediately

preceding 1995. See § 936(j)(2)(B), (3)(A), (4), (5).

Though the cap was based on past activity, it was not

entirely fixed. Under certain circumstances, if a taxpayer

acquired a trade or business that itself qualified for the credit,

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the acquiring taxpayer could add to its own cap the historic tax

attributes of the acquired trade or business, enabling the

acquiror's new cap to reflect the historic credit-eligible

expenditures of both entities. See § 936(j)(5)(D); accord H.R.

Rep. No. 104-737, at 292 (1996) (Conf. Rep.) ("The adjusted base

period income of the existing credit claimant from which the assets

are acquired is divided between such corporation and the

corporation that acquires such assets."). The selling corporation

would then subtract from its cap the same amounts.

B. OMJ's Transactions

OMJ is a Delaware corporation that (among other things)

develops, manufactures, and distributes healthcare products. Its

principal place of business is Puerto Rico. Between 1993 and 1998,

OMJ reported income from manufacturing operations in Puerto Rico. 

The parties agree that throughout the period on which this

litigation is focused, OMJ remained eligible to claim the section

936 credit.

On November 30, 1998, OMJ transferred three of its

wholly-owned subsidiaries--Janssen Ortho, LLC, Ortho Biologics,

LLC, and Lifescan, LLC--to a fourth company. That fourth company,

OMJ Ireland, Ltd. ("OMJ Ireland"), was an Irish corporation also

owned entirely by OMJ. OMJ Ireland had never paid or been required

to pay U.S. income taxes.

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After the transfers, OMJ paid income tax for 1999 and

2000 in the amounts it would have owed had its credit cap been

reduced by the amount associated with the three businesses it sold. 

Later, however, OMJ filed two amended returns, claiming a refund of

$27,537,675 (which it later adjusted to $22,874,764) for 1999 and

a refund of $37,928,839 (which it later adjusted to $30,094,104)

for 2000, justifying each on the ground that the credit cap

reduction was unnecessary. The Internal Revenue Service disagreed

and denied the refunds. OMJ, in pursuit of its refund claims,

filed this suit soon afterwards.

The district court, concluding that section 936 required

a credit cap reduction upon the sale of any trade or business, no

matter who the buyer, granted summary judgment to the United

States. OMJ appealed.

II. Standard of Review

We review the district court's grant of summary judgment

de novo. Shafmaster v. United States, 707 F.3d 130, 135 (1st Cir.

2013); see also Prokey v. Watkins, 942 F.2d 67, 72 (1st Cir. 1991)

(reciting the "familiar" principle that summary judgment is

"appropriate when the pleadings and other submissions 'show that

there is no genuine issue as to any material fact and that the

moving party is entitled to judgment as a matter of law.'" (quoting

Fed. R. Civ. P. 56)). In conducting our de novo review, we accord

to the IRS Commissioner "a presumption of correctness, so the

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taxpayer bears the burden of proving that an assessment was

erroneous." Shafmaster, 707 F.3d at 135 (citing Hostar Marine

Transp. Sys., Inc. v. United States, 592 F.3d 202, 208 (1st Cir.

2010)). Adding heft to this burden is the principle, applicable

here, that because "[i]ncome tax deductions and credits are matters

of legislative grace," MedChem (P.R.), Inc. v. Comm'r, 295 F.3d

118, 123 (1st Cir. 2002), "credit should be allowed only where

there is 'clear provision therefor.'" Id. (quoting New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)).

III. Analysis

This case arises in part because neither Congress nor the

IRS wrote any rules for implementing the details of the credit cap

adjustments. Rather, in the portion of the tax code governing the

possessions credit transition period, Congress provided as follows:

"ACQUISITIONS AND DISPOSITIONS.--Rules similar to the rules of

subparagraphs (A) and (B) of section 41(f)(3) shall apply for

purposes of this subsection." 26 U.S.C. § 936(j)(5)(D). 

Section 41(f)(3), which has nothing to do with the possessions

corporation tax regime aside from this cross reference, generally

governed the calculation of the tax credit for increases in

research expenditures. The parties are in agreement that section

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936 should be interpreted to create a framework as similar as

possible to section 41's.1

We take it as an undisputed given that Congress looked to

section 41 because that section implemented a framework, like the

one created by section 936, under which calculation of a tax

benefit was driven in great part by the taxpayer's experience in

prior years. In creating the credit for expenditures on qualified

research, Congress chose to limit the credit to increases in

research spending. In simplified form, research spending in a

given year established a floor above which such spending had to

rise in a subsequent year in order to justify a credit, which would

be limited to the incremental increase.

The comparison of one year to another for calculating the

credit under section 41 posed the question of what to do when a

company sold a line of business to which some or all of the prior

year's research expenditures were devoted. For example, a company

buying such a line of business might plausibly claim to have

incrementally increased its own research spending in the year

following the acquisition, even though it merely added to its prior

research spending that of the acquired business line. In adopting

1

 At oral argument, the government emphasized that section

936 and section 41(f)(3) "have to be applied the same way," and

that "whether the attributes go away, or go to the acquiror, has to

be the same in both cases." There being nothing in the statute or

legislative history to compel a different reading, we adopt here

the parties' preferred construction.

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section 41(f)(3), Congress rejected that position, instead

reflecting in the statute its judgment that such transactions

involve mere shifts of spending from firm to firm, rather than

increases in overall research spending. Accord H.R. Rep. No. 97-

201, at 124-25 (1981) ("If the provision did not include rules for

changes in ownership of a business, a taxpayer who begins business

by buying and operating an existing company might be entitled to a

credit even if the amount of qualified research expenditures were

not increased."). To avoid creating a tax credit for such shifts,

Congress provided as follows:

(3) Adjustments for certain acquisitions, etc.--Under

regulations prescribed by the Secretary– 

(A) Acquisitions.--If, after December 31, 1983, a

taxpayer acquires the major portion of a trade or

business of another person (hereinafter in this paragraph

referred to as the "predecessor") or the major portion of

a separate unit of a trade or business of a predecessor,

then, for purposes of applying this section for any

taxable year ending after such acquisition, the amount of

qualified research expenses paid or incurred by the

taxpayer during periods before such acquisition shall be

increased by so much of such expenses paid or incurred by

the predecessor with respect to the acquired trade or

business as is attributable to the portion of such trade

or business or separate unit acquired by the taxpayer,

and the gross receipts of the taxpayer for such periods

shall be increased by so much of the gross receipts of

such predecessor with respect to the acquired trade or

business as is attributable to such portion.

26 U.S.C. § 41(f)(3) (amended 2013).

And to address the opposite problem--the possibility that

a company that merely sold a line of business might be faulted for

decreasing its research (even though that research was continued by

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another)--Congress addressed the sell side of such transactions in

the next subparagraph:

(B) Dispositions.--If, after December 31, 1983– 

(i) a taxpayer disposes of the major portion of any

trade or business or the major portion of a

separate unit of a trade or business in a

transaction to which subparagraph (A) applies, and 

(ii) the taxpayer furnished the acquiring person

such information as is necessary for the

application of subparagraph (A),

then, for purposes of applying this section for any

taxable year ending after such disposition, the amount of

qualified research expenses paid or incurred by the

taxpayer during periods before such disposition shall be

decreased by so much of such expenses as is attributable

to the portion of such trade or business or separate unit

disposed of by the taxpayer, and the gross receipts of

the taxpayer for such periods shall be decreased by so

much of the gross receipts as is attributable to such

portion.

Id.

Staying for the moment with the treatment of the research

credit floor, the question posed by analogy in this case is how to

treat a seller under section 41(f)(3)(B) when a line of business is

sold to a foreign corporation that pays no U.S. corporate income

tax and to whom there would therefore be no basis for an adjustment

under the buy-side provision of subparagraph (A). OMJ argues that

in such a case, the seller would not have been entitled to decrease

its research credit floor, because such a decrease was required

only after a transaction that triggers a buy-side increase under

subparagraph (A). And if the sale would not have decreased the

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seller's research credit floor, reasons OMJ, then it cannot have

decreased its possessions tax credit cap.

The United States balks at OMJ's straightforward reading

of section 41(f)(3). The government argues that

section 41(f)(3)(A) would indeed "apply" to an acquisition of a

business line by any "acquiring person," whether or not that person

paid any U.S. corporate income tax--which is to say, whether or not

there could be any buy-side increase in the research credit floor. 

The government's reading, however, would mean that the sell-side

adjustments are made any time there is a sale of a trade or

business, because in every sale there is an acquiror. But if

Congress had intended such a result, it could easily have so

stated, and there would have been no reason for the cross-reference

to subparagraph (A). Indeed, the cross-reference in (B) to

"transaction[s] to which subparagraph (A) applies" strongly

indicates that there must be some dispositions of credit-generating

trades or businesses to which subparagraph (A) does not apply,

unless the last eight words of subparagraph (B)--"in a transaction

to which subparagraph (A) applies"--are to be treated simply as

surplusage. See generally Duncan v. Walker, 533 U.S. 167, 175

(2001) ("We are . . . reluctan[t] to treat statutory terms as

surplusage . . . ." (alteration in original) (internal quotation

marks omitted)); MedChem (P.R.), Inc. v. Comm'r, 295 F.3d 118, 125-

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26 (1st Cir. 2002) (rejecting an interpretation of section 936 that

would have rendered a term redundant).

The government briefly argues that because the Department

of the Treasury has, by regulation, defined the term "acquisition"

to include a "liquidation," see Treas. Reg. § 1.41-7(b), it follows

that any liquidation of a major portion of a business can generate

a subparagraph (B) reduction--even if the liquidation does not

result in a corresponding increase in the research credit floor of

a buyer. The failures of this logic are manifold. Most

importantly, the argument assumes that if the word "acquisitions"

is defined to include a particular type of transaction, then any

transaction of that type will give rise to a decrease under

subparagraph (B). But the rule that dictates the outcome in this

case has nothing to do with the breadth of the term

"acquisitions"--a term that appears nowhere in subparagraph (B). 

Instead, we are guided by the basic principle (on which regulation

§ 1.41-7(b) casts precisely no doubt) that subparagraph (B) applies

only to dispositions involving transactions "to which subparagraph

(A) applies." Liquidation or not, a transaction that does not

involve a buyer is not one to which subparagraph (A)--a provision

aimed explicitly and exclusively at the behavior of a purchaser of

a major portion of a trade or business--applies. 

The government's fallback position is that even if

subparagraph (A) does not apply to every transaction involving a

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credit-generating business, it applies whenever the acquiror may be

subject to payment of any type of U.S. tax, whether or not it pays

the type of tax--corporate income tax--that could be affected by an

increase in the research credit floor. We cannot agree. 

Subparagraph (A) refers not only to "a taxpayer," but also to

modifications of qualified research expenses and gross receipts--

modifications that are possible only if the acquiring party is

subject to the sorts of taxes to which the credits at issue apply. 

To say that subparagraph (A) "applies," therefore, is to suggest

that there is something that might undergo the specified

adjustments. The government's myopic focus on the term "taxpayer"

simply obscures the broader point that, "taxpayer" or not, a sale

to an entity that has no obligations under subparagraph (A) is not

a transaction to which subparagraph (A) applies.

This reading of subparagraph (A) is reinforced by

unambiguous textual indications elsewhere in section 41(f)(3). For

example, although the government argues that subparagraph (B)(ii)

broadens subparagraph (B)'s applicability by referring to an

"acquiring person," rather than an "acquiring taxpayer,"

subparagraph (B)(ii) in fact explicitly restricts the scope of that

provision by expressing the additional requirement that in order to

avail itself of a decrease, a sell-side taxpayer must "furnish[]

the acquiring person such information as is necessary for the

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application of subparagraph (A)." We glean two points from this

language.

First, the language confirms that not every sale results

in a decrease in the research credit floor. If the seller fails to

give the buyer the "information as is necessary for the application

of subparagraph (A)," the subparagraph (B) reduction does not

occur.

Second, and even more saliently, the statute's

recognition that information is needed from the seller in order to

allow "application of subparagraph (A)" strongly implies that

"application" means some adjustment to the buyer's U.S. corporate

tax attributes. The "application of subparagraph (A)" thus most

naturally means the use of subparagraph (A) to require an increase

in the buyer's research credit floor. And although the government

relies on legislative history to suggest that Congress understood

the interaction of subparagraphs (A) and (B) differently, that

history demonstrates precisely the opposite. See H.R. Rep. No. 97-

201, at 125 (1981) ("This relief [i.e., the subparagraph (B)(ii)

decrease] is not provided unless the taxpayer furnishes the

acquiring person with information needed to compute the credit

under the acquisition rules described in [subparagraph (A)]."). In

short, section 41(f)(3)'s language and legislative history compel

the conclusion that the decrease under subparagraph (B) cannot

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occur when the buyer is not a U.S. corporate taxpayer, because in

such a case, subparagraph (A) cannot apply.

Undaunted by these considerations, the United States

proposes that we disregard the strong indications given by the

language of subparagraphs (A) and (B) in favor of certain policy

concerns that it suggests animated Congress's adoption of the

provisions at issue. Given the government's insistence that we

interpret section 936 as creating an adjustments regime as similar

as possible to the one under section 41(f)(3), one might reasonably

expect such policy arguments to focus primarily on the concerns

underlying the research increase tax credit. But instead, the

government points us to subparagraph 936(j)(9)(B), a provision with

no section 41 analog, which states that "[i]f . . . a corporation

which would (but for this subparagraph) be an existing credit

claimant adds a substantial new line of business [other than one

that itself counts as an existing credit claimant] such corporation

shall cease to be treated as an existing credit claimant . . . ."

The government suggests that subparagraph (j)(9)(B)

evinces Congress's intention to prevent corporations from claiming

possessions tax credits for so-called organic growth. And the

district court, though observing that such an at-all-costs pursuit

of that policy would be "difficult to reconcile" with subparagraph

(B)'s plain indication that a decrease is required only in the

event of a corresponding increase, nevertheless agreed. It is on

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this argument that the United States, largely waving to one side

section 41's language, relies most heavily on appeal.

If the organic growth to which the government refers is

the building of a new line of business that did not previously

account for existing credits, then the government is certainly

correct that subparagraph 936(j)(9)(B) evidences a disfavoring of

such growth as a basis for credit generation. But there is no

claim that OMJ grew such a new line of business. And while it is

true that OMJ's construction of section 936(j)(5)(D) would likely

not have benefitted OMJ unless it had some new income against which

to apply the credit retained following the sales, Congress

manifested no intention to disfavor use of the credit to offset

income earned as a result of growth within pre-existing, retained

lines of business. Indeed, the fact that Congress limited

section 936(j)(9)(B) to the addition of new business lines

evidences a decision not to apply its concepts to what would have

been an obvious other form of growth not included in

subsection 936(j)(9)(B). In this regard, subsection 936(j)(9)(B)

actually undercuts the government's position.

The government's suggestion that Congressional intent

requires us to read subparagraph (j)(9)(B) more broadly than its

text would seem to allow also runs counter to the principle that,

as a general matter, "[t]he best indication of Congress's

intentions . . . is the text of the statute itself." E.g., South

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Port Marine, L.L.C. v. Gulf Oil Ltd. P'ship, 234 F.3d 58, 65 (1st

Cir. 2000); see also In re Rudler, 576 F.3d 37, 44 (1st Cir. 2009)

("If the statute's language is plain, 'the sole function of the

courts--at least where the disposition required by the text is not

absurd--is to enforce it according to its terms.'" (quoting Lamie

v. United States, 540 U.S. 526, 534 (2004) (internal quotation

marks omitted))). Whether or not we call the text of 41(f)(3)

indisputably plain, all must agree that it does not read as one

would expect it to had Congress intended that all sales of business

lines would decrease a seller's cap. And, as we have observed, the

legislative history supports this reading of section 41(f)(3) by

confirming that Congress understood that a decrease would be

available only when triggered by a buy-side increase.

Our interpretation is reinforced further by stepping back

from a microscopic examination of a particular transaction and

looking at the general impact of the parties' competing

interpretations. Both the structure of the statute and the entire

nature of the possessions tax regime make clear that the object of

Congress's attention was the Puerto Rican economy. In terminating

the possessions tax regime, Congress apparently intended to provide

a transition period during which pre-existing credits for existing

lines of business would generally remain viable, neither increasing

nor decreasing. Section 936 furthers this apparent aim by ensuring

that any increases in caps on the buy side would be offset by

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decreases on the sell side, leaving the balance of caps in Puerto

Rico as a whole largely unaffected. To have required a decrease

when there could have been no increase would have thrown off that

balance and marginally decreased the size of the transitional

cushion. We see no indication that such was Congress's intent. 

Nor does the government claim that the reading of sections 41 and

936 for which OMJ advocates could be exploited to increase the

total amount of credit claimed beyond the amount that could have

been claimed but for the sale. Indeed, given that the section 936

transition period long ago expired,2 the government can point to no

adverse collateral effects of applying the statute as it most

naturally reads.

IV. Conclusion

As we observed at the outset of our discussion of

section 936, the government adopted no rules addressing exactly how

section 936(j)(5)(D) would work. Instead, the government joins

with OMJ in suggesting that the framework must replicate, as much

as is possible, the rules expressed in section 41(f)(3). The

2

 Congress recently amended section 41(f)(3) to replace the

phrase "taxpayer" in subparagraph (A) with the phrase "acquiring

person," mooting for future research credit cases any need to

decide what the word taxpayer means. See American Taxpayer Relief

Act of 2012, Pub. L. No. 112-240, § 301(b), 126 Stat. 2313, 2326-

2328 (2013). Naturally, OMJ suggests that this reflects Congress's

determination that a policy change was due, while the government

suggests that the amendment was intended to codify what has always

been understood. In light of our conclusion that other sources of

insight render the statute's meaning unambiguous, neither argument

exerts much force.

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language, structure, purpose, and history of those rules point

uniformly to the conclusion that a reduction in a seller's cap as

a result of the sale of a business line is appropriate only in the

event of a corresponding increase in the buyer's cap. And since

there is no claim that the transaction at issue in this case

increased or could have increased any credit cap attributed to OMJ

Ireland or its subsidiaries, the transfers did not reduce OMJ's

credit cap. We therefore reverse the district court's order

granting summary judgment to the United States and remand for the

entry of summary judgment in OMJ's favor.

So ordered.

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