t c no united_states tax_court medchem p r inc petitioner v commissioner of internal revenue respondent medchem products inc petitioner v commissioner of internal revenue respondent docket nos filed may p-usa is a corporation that is headquartered and has its manufacturing_facility in the united_states its wholly owned subsidiary is p-pr which lists as its headquarters officers and directors the headquarters officers and directors of p-usa a is a corporation unrelated to ps that manufactures in puerto rico a drug named avitene on date a and certain related entities sold to ps the equipment technology and other assets except a’s manufacturing_facility in puerto rico connected to avitene’s manufacturing as part of the sale a agreed to continue manufacturing avitene primarily for p-pr using the facility and labor furnished by a and the raw materials and equipment furnished by p-pr a also used p-usa’s technology in return p-pr generally agreed to pay a a fee equal to its manufacturing costs plus percent throughout most of the relevant period p-pr had no employees and -- - reported as its primary source_of_income receipts from the sale of avitene p-pr deducted from those receipts amounts that it paid to p-usa and a for labor that they expended on avitene’s manufacturing process p-pr claimed on its federal_income_tax return that it was entitled to a dollar_figure puerto rico and possession_tax_credit under sec_936 i r c ps argue that p- pr met the active_conduct_of_a_trade_or_business within a u s possession requirement of sec_936 b i r c by virtue of a’s activities in puerto rico the fact that a manufactured avitene using p-pr’s raw materials and equipment the fact that p-pr continued to own the raw materials from the time that it received them until the time that it sold them in their manufactured form as avitene and the fact that p-pr paid p-usa and a for the cost of their labor connected to the avitene manufacturing process held p-pr did not actively conduct a trade_or_business in puerto rico as required by sec_936 b i r c e p-pr did not participate regularly continually extensively and actively in the management and operation of a profit--motivated activity in that possession david a hickerson for petitioners theodore j kletnick alan s kline george curran jennifer allan kassabian marie e small and melanie a garger for respondent opinion laro judge these consolidated cases were submitted to the court without trial see rule respondent determined an dollar_figure deficiency in the federal_income_tax of medchem p r inc medchem p r for its taxable_year ended date respondent determined a dollar_figure deficiency in the federal_income_tax of medchem products inc subsidiaries medchem - - group for its taxable_year ended date following concessions we must decide whether medchem p r meets the active_conduct_of_a_trade_or_business within a possession requirement of sec_936 b we hold it does not unless otherwise indicated section references are to the internal_revenue_code applicable to the relevant years rule references are to the tax_court rules_of_practice and procedure we attach hereto as appendix a a summary of some of the critical events that occurred during the -month period from date to date that preceded the 3-year test period relating to our determination under sec_936 b the 3-year test period from date to date and the 20-month period from date to date that followed the 3-year test period ’ background the parties have filed with the court a stipulation of facts and certain related exhibits we incorporate herein by reference ' given that holding we need not and do not decide the parties’ other dispute to wit whether medchem p r manufactures or produces a product in the possession as required by sec_954 d a we take into account petitioners’ actions in years subseguent to their taxable_year to evaluate their prospects during their year see 832_f2d_403 n 7th cir tax_court allowed to rely on subsequent events to determine whether those events were consistent with the court’s judgment of the facts available in the year in issue affg 87_tc_698 q4e- the stipulated facts and exhibits we find the stipulated facts accordingly and we set forth the relevant facts in this background section medchem products inc medchem u s a is a massachusetts corporation whose principal_place_of_business is in woburn massachusetts woburn medchem u s a succeeded medchem p r following the subject years through a merger of the latter into the former medchem p r was incorporated in delaware on date as medchem puerto rico inc it changed its name on date to biochem products inc it changed its state of incorporation on date to massachusetts and it changed its name on date to medchem p r medchem p r and its predecessors each hereinafter referred to as medchem p r were always wholly owned subsidiaries of medchem u s a the original books_and_records of medchem p r and medchem u s a are maintained in woburn on an accrual_method of accounting and on the basis of a fiscal_year ending on august during each of medchem p r ’s taxable years ended on date and all of its reported income was intangible_property_income sec_936 attributable to the sale of avitene a pharmaceutical manufactured in puerto rico by alcon puerto rico inc alcon p r an unrelated entity avitene is a blood clotting drug that is manufactured from the interior - collagen-rich lining corium of cowhides it is used during surgery to control bleeding it was primarily manufactured by alcon p r during the relevant years in the forms of 35x70 mm nonwoven web and gram finished flour medchem u s a leases office research and manufacturing facilities in woburn it leased big_number square feet in and it sec_63 full-time employees on date worked in that space on date medchem u s a leased approximately big_number square feet at two facilities in woburn medchem u s a ’ sec_144 full-time employees on date worked at medchem u s a ’s manufacturing facilities in woburn and san antonio texas the individuals who were connected with the avitene manufacturing and sales business avitene business were employed by medchem u s a medchem p r alcon p r or kelly services inc kelly a supplier of temporary labor each medchem u s a employee connected with avitene was paid_by medchem u s a and had his or her office at medchem u s a ’s facility in woburn medchem p r had no employees after date medchem p r ’s only employee before date was jose perez and medchem p r terminated him on date nor did any of medchem p r ’s officers or directors have an office in puerto rico after date all of medchem p r ’s officers and directors except mr perez were officers and or directors of medchem u s a and after date none of officers or directors was paid_by medchem p r medchem p r ’s the individuals connected with the avitene business are listed below by name affiliate office location period of affiliation in the listed capacity name acosta eugenia alifonso ramon brophy frank carrion jimmy castro raymond donaldson jonathan paul ariel daniel falvey ferdman geffken lee domenic sean hansen micale moran mcdonough john perez jose rivera luis rodriguez maria rudolph cathy santiago maria severance scott shepherd ronald singer steven james bernard stevens sullivan david swann tanny velez jay nelson position and office period of affiliate location position affiliation medchem u s a woburn manager quality system sec_1 alcon p r p r director of manufacturing medchem u s a woburn vice president-mkt sale sec_2 vice president-marketing alcon p r p r avitene production manager kelly alcon p r p r planner buyer medchem u s a woburn director president chief oper off clerk medchem p r woburn president secretary director medchem u s a woburn assistant treasurer medchem u s a woburn dir of core technology medchem u s a woburn treasurer chief financial officer medchem p r woburn treasurer assistant secretary secretary alcon p r p r general plant manager medchem u s a woburn production supervisor t medchem u s a woburn treasurer medchem p r woburn secretary clerk treasurer medchem u s a woburn financial employee medchem p r p r general manager assistant treasurer kelly p r planner buyer alcon p r p r avitene prod supervisor medchem u s a woburn quality assurance worker t alcon p r p r director quality assur medchem u s a woburn vice president operation sec_1 medchem u s a woburn dir materials manager medchem u s a woburn assistant clerk medchem p r woburn assistant secretary clerk medchem u s a woburn dir qlty control assur medchem u s a woburn vice president-operations sr vice president-operat medchem p r woburn director medchem u s a woburn director chairman chief_executive_officer medchem p r woburn director chairman medchem u s a woburn cost accountant t alcon p r p r planner buyer 'the individual’s affiliation occurred sometime between date and date medchem u s a amvisc which is unrelated to avitene initially sold only one product amvisc is a hyaluronic-acid-based - product used to lubricate and separate tissues in ophthalmic surgical procedures medchem u s a decided in to diversify its operations by acquiring the avitene business from alcon p r which at the time was avitene’s manufacturer and seller medchem u s a ’s decision was based in part on the fact that it was being sued for patent infringement as to amvisc the plaintiffs in that lawsuit had commenced the lawsuit in and were seeking an injunction and treble_damages on date petitioners entered into a series of agreements with alcon p r alcon pharmaceuticals ltd alcon pharmaceuticals and alcon laboratories inc alcon labs these three alcon entities are collectively referred to as the alcon entities to purchase the avitene business for approximately dollar_figure million the agreements included three asset purchase agreements three noncompetition agreements a guaranty and a processing agreement all of the alcon entities were related and none of the alcon entities was related to either petitioner the assets sold under the asset purchase agreements generally included all avitene inventories all tangible assets used to manufacture avitene and all avitene-related intangible assets such as receivables contract rights and intellectual_property under the first agreement alcon labs sold to medchem u s a receivables valued at dollar_figure a non-competition - - agreement valued at dollar_figure goodwill valued at dollar_figure contract rights valued at dollar_figure and records valued at dollar_figure alcon labs sold to medchem p r receivables valued at dollar_figure million and inventory valued at dollar_figure million under the second agreement alcon p r sold to medchem u s a patents and related know-how valued at dollar_figure million trademarks valued at dollar_figure million various food and drug administration fda approvals including the pre-market approval for avitene valued at dollar_figure a non-competition agreement valued at dollar_figure goodwill valued at dollar_figure and contract rights valued at dollar_figure under the third agreement alcon p r sold to medchem p r inventory valued at dollar_figure million and machinery and equipment valued at dollar_figure the machinery and equipment had been used by alcon p r to manufacture avitene and was located in alcon p r ’s avitene manufacturing_facility in humacao puerto rico humacao that facility consisted of the avicon avitene plant two unrelated plants warehouse space and administrative offices fach of the asset purchase agreements required that the alcon entities manufacture and sell to petitioners big_number pounds of corium and provided that the alcon entities had to refund to petitioners the entire amount_paid for the avitene business plus interest if the corium could not be manufactured by date at all times during the 3-year period ended august --- - avitene was manufactured using the patents know-how product specifications as reflected in the fda pre-market approvals and goodwill owned by medchem u s a medchem p r held the legal_title to all of the avitene manufacturing equipment the raw materials used to manufacture avitene the avitene work-in-process and the finished avitene inventory until sold when the finished avitene was shipped from the alcon p r facility title passed to the purchaser which in all cases but one was medchem u s a medchem p r would invoice medchem u s a or the other purchaser for the avitene sold to it ata price equal to medchem p r ’s manufacturing cost plus percent from date through date medchem u s a distributed marketed and sold avitene from its offices in woburn medchem p r played no part in these sales or in the other sales of avitene to end users the labels which medchem p r used during its fiscal_year ended date the sole exception concerned the sale of avitene for distribution in japan through date in that case medchem p r sold avitene to alcon pharmaceuticals which owned the distribution rights to the japanese market until date title to that avitene passed to alcon pharmaceuticals when the finished avitene was shipped from the alcon p r facility alcon pharmaceuticals sold the distribution rights to the japanese market to medchem u s a on date for dollar_figure million and medchem u s a transferred those rights to medchem p r on date medchem p r ’s sales of avitene for the japanese market accounted for approximately percent of its total net sales of avitene -- - designated alcon p r as avitene’s manufacturer the labels read manufactured by alcon p r humacao puerto rico oo0o661 for medchem p r humacao puerto rico oo0o661 distributed by medchem u s a woburn massachusetts neither petitioner acquired under the asset purchase agreements alcon p r ’s avitene-manufacturing facility in humacao or the right to market distribute or sell avitene in japan that right to the japanese market was initially retained by alcon pharmaceuticals which during the period of retention purchased avitene for the japanese market from medchem p r alcon p r manufactured the avitene sold to alcon pharmaceuticals and treated it the same as all other avitene for purposes of scheduling planning and buying manufacturing and quality control the respective parties to the non-competition agreements were medchem u s a and alcon labs medchem u s a and alcon pharmaceuticals and medchem u s a and alcon p r under these agreements the alcon entities generally promised not to manufacture market or sell any product having the same or neither petitioner has ever had an avitene manufacturing_facility in puerto rico substantially the same form function or application as avitene during the 5-year period commencing on date medchem u s a gave the guaranty to each of the alcon entities under the guaranty which was in effect throughout the fiscal_year ended date medchem u s a guaranteed to pay any debt and perform any obligation of medchem p r arising from the asset purchase and related agreements the processing agreement dealt primarily with a promise by alcon p r to manufacture avitene for medchem p r using alcon p r ’s facility and labor and medchem p r ’s raw materials and equipment alcon p r also used medchem u s a ’s technology but not pursuant to the processing agreement see appendix b for the relevant provisions of the processing agreement the processing agreement expired initially on date but was extended on four separate occasions to date date date and the earlier of date or the date on which alcon p r completed a set delivery schedule respectively from date through date alcon p r manufactured avitene for medchem p r pursuant to the processing agreement and alcon p r sent its invoices for its manufacturing services directly to medchem u s a for payment from the account of medchem p r alcon p r manufactured avitene at its manufacturing_facility in humacao using its own personnel to manufacture test and package avitene and to supervise each of these functions alcon p r was solely responsible for resolving any problem that arose during the period from the time that it received the corium up until the time that the finished avitene was delivered to a carrier for delivery to medchem u s a manufacturing process alcon p r generally manufactured avitene in accordance with a two-phase process and kept its inventory of finished avitene in its warehouse attached to its manufacturing_facility avitene’s two-phase manufacturing process was as follows phase i frozen corium and component materials were ordered from the warehouse attached to the avitene manufacturing_facility and transferred to a preparation room in the facility where the corium was thawed and machine washed the corium was machine cut into approximately square inch pieces manually inspected for imperfections and machine cut into smaller pieces of approximately one square inch in size the smaller pieces were acidified washed with alcohol and tested against product specifications the resulting product was refrigerated while the initial steps were repeated for a second lot of corium the two lots were mixed together and dried ina rotary dryer the dried corium was machine milled into a loose powdery fibrous substance known as bulk flour the bulk flour was placed in quarantined cages awaiting further processing into its final form as either finished flour or nonwoven web phase ii as to the manufacturing of nonwoven web bulk flour was transferred from the quarantined cage to the web forming room where it was machine processed into rolls of nonwoven web the rolls of nonwoven web were transferred to the web cutting room where they were machine cut into the required size visually inspected against product specifications and placed in trays for drying and sterilization once sterilized the nonwoven web was transferred to the pouch load and seal room where it was packaged in a sealed pouch the packaged nonwoven web was sterilized tested and transferred to the loading and shipping area as to the manufacturing of finished flour jars were machine washed loaded into trays and carts and dried in a walk-in oven the jars were moved to the filling process room where they were filled with bulk flour and placed back into an oven for further drying the dried jars with bulk flour inside were transferred by carts to the capping room where they were capped the capped jars with bulk flour inside were transferred by conveyor to the canning and sealing room where they were canned banded and sealed with tamper- proof material the resulting jars with bulk flour inside were moved to the sterilization room where they were oven sterilized and transferred to the loading and shipping area petitioners entered into the processing agreement to ensure a reliable supply of avitene while they proceeded to establish medchem p r ’s own avitene manufacturing_facility in puerto rico when the date agreements were entered into petitioners intended to have that facility ready to take over the manufacturing of avitene at the end of the processing agreement’s original 3-year term in date jonathan donaldson traveled to humacao and interviewed mr perez for a position with medchem p r at the time mr perez was involved in and familiar with all aspects of the avitene manufacturing process he was a longtime alcon p r employee with various supervisory responsibilities as to avitene’s manufacturing shortly thereafter while in woburn mr donaldson decided to hire mr perez and communicated that decision to mr perez in puerto rico mr perez accepted mr donaldson’s offer and worked for medchem p r until date reporting directly to bernard sullivan or to mr sullivan’s superior mr donaldson mr perez worked from date through date primarily out of a one-room office the only office that medchem p r maintained in humacao during that period the office was equipped with three desks a computer a facsimile machine a photocopier and file cabinets the office contained product specifications standard operating procedures invoices and copies of some of the financial statements and records which would be needed in the event of an audit medchem p r paid mr perez an annual salary plus benefits to manage and coordinate its efforts in puerto rico as to the this was one of the infrequent occasions on which mr donaldson or any of either petitioner’s other officers or directors traveled to puerto rico on avitene business -- - manufacturing of avitene from date through approximately date mr perez spent approximately percent of his time visiting alcon p r ’s avitene manufacturing operation making sure that the operation was running smoothly and aiding the anticipated transfer of that operation to medchem p r he spent the remainder of his time during that period on medchem p r ’s effort to establish its own avitene manufacturing_facility in puerto rico during the remainder of his employment by medchem p r mr perez spent approximately percent of his time working on medchem p r ’s proposed facility and the rest of his time on alcon p r ’s avitene manufacturing operation and the daily operation of medchem p r ’s humacao office mr perez was the only employee that medchem p r ever had during the relevant years medchem p r did hire three independent contractors carlos moya maria pastrana and wanda rodriguez to assist mr perez in the humacao office ms pastrana and mr moya worked in the office during and wanda rodriguez worked in the office from date to date mr moya was a materials coordinator and ms pastrana and her successor ms rodriguez were administrative secretaries medchem p r directly paid these three individuals and issued to them forms 1099-misc miscellaneous income reporting these payments as nonemployee compensation - on date medchem p r paid dollar_figure to the puerto rico industrial development co for approximately acres of land in juncos puerto rico juncos to be used as the site of medchem p r ’s proposed manufacturing_facility conditions of the sale included that medchem p r would submit plans for construction of an industrial building within months that construction of the building would begin within months of the plans’ approval that the completed building would be devoted to manufacturing operations for a minimum period of years that the building would include big_number square feet of ground floor space and big_number square feet of mezzanine space and that medchem p r would use its reasonable efforts to employ people at the commencement of the facility’s manufacturing operations and people within months thereafter petitioners anticipated that the proposed facility would cost at least dollar_figure million to build and through date medchem p r made dollar_figure of capital expenditures relating to the facility’s proposed construction most of these expenditures concerned the services of unipro an engineering and architectural firm retained by medchem p r to work on the proposed facility unipro prepared architectural drawings and designs for the facility in early medchem u s a suffered a devastating financial blow from the amvisc litigation on date the district_court hearing the case issued a preliminary injunction barring medchem u s a from using manufacturing and selling amvisc in the united_states amvisc and avitene were medchem u s a ’s only products medchem u s a faced the possible payment of costly patent infringement damages multiple damages and an award of attorney’s fees the amvisc injunction caused medchem u s a to default on dollar_figure million in debt and to lay off a third of its workforce the amvisc injunction caused petitioners to postpone indefinitely their plans to construct an avitene manufacturing_facility in puerto rico petitioners took several steps regarding avitene in early following the amvisc injunction first in connection with suspending their plans to construct the manufacturing_facility in puerto rico they notified unipro to stop its work on that facility second in date medchem p r wrote off for financial_accounting and tax purposes all of the capitalized expenditures dollar_figure relating to the proposed facility third medchem p r closed its humacao office and terminated the workers there mr perez and wanda rodriguez in connection therewith mr perez transferred to alcon p r all of the records as to suppliers and vendors which had been kept in the humacao office and he transferred to medchem u s a ’s woburn facility all of the other records which had been kept in the office including records relating to the design and construction of medchem p r ’s proposed facility in puerto rico fourth -- - petitioners decided to move during the fall of the avitene manufacturing process including the manufacturing equipment from alcon p r ’s puerto rico facility to medchem u s a ’s idled amvisc facility in woburn such a move would and did require medchem u s a to make additional leasehold improvements in order to conform the amvisc facility to avitene’s manufacturing requirements fifth medchem p r attempted to sell the land in juncos that it had purchased for the site of the proposed facility sixth as of date medchem u s a employees wrote all of medchem p r ’s checks in woburn and mailed those checks from woburn to the payees petitioners moved the equipment used to process corium into bulk flour into medchem u s a ’s woburn facility in date ’ within months they moved into that facility all or part of the frozen corium and the equipment used to process bulk flour into medchem u s a eventually constructed a bulk avitene manufacturing_facility in woburn in date and began producing bulk avitene there months later in date medchem u s a began constructing an avitene finished goods manufacturing_facility in woburn at that time alcon p r performed that part of the avitene manufacturing process at its facility in puerto rico pursuant to the processing agreement medchem u s a substantially completed construction of the latter project in date at which time medchem u s a controlled avitene’s entire manufacturing process ’ at that time the manufacturing of work-in-process was completed and the machinery and equipment used in that process disassembled and also readied for moving to woburn nonwoven web these two groups of equipment constituted all of the manufacturing equipment necessary to perform the work in phase of the manufacturing process as of the later date all of the manufacturing equipment related to phase was located in medchem u s a ’s facility in woburn by date petitioners had also transferred certain raw material manufacturing functions into medchem u s a ’s woburn facility as well the equipment used to perform the work in phase of the manufacturing process e processing bulk flour into finished flour and finishing and packaging the nonwoven web remained in alcon p r ’s manufacturing_facility in humacao until early at which time it was shipped to the woburn facility alcon p r continued in puerto rico until early to manufacture finished avitene from bulk flour and dry sterilize and package nonwoven web under the terms of the processing agreement alcon p r did so using bulk flour and nonwoven web that had been manufactured in humacao during a buildup in and it did not use any bulk flour or nonwoven web manufactured elsewhere when petitioners moved the bulk and nonwoven web equipment to medchem u s a ’s facility in alcon p r planned to use the part of on separate occasions medchem u s a reported to the securities_and_exchange_commission sec that as of date and as of date respectively medchem u s a was in the process of redesigning its amvisc manufacturing_facility in woburn in order to start manufacturing avitene there - - the plant where the equipment had been located for non-avitene products alcon p r devoted to of its full-time production line employees to the manufacturing of avitene before date and it devoted to of its full-time production line employees afterwards alcon p r included the compensation paid to these employees in the calculation of the processing fee charged to medchem p r under the processing agreement of the to production line employees who worked on avitene before date approximately to worked in phase of the manufacturing process and the remainder worked in phase the number of alcon p r employees producing avitene decreased in date after medchem u s a moved to woburn the equipment used to convert corium into bulk flour all of the production line employees were supervised by a manager employed by alcon p r namely maria rodriguez from date to date and jimmy carrion afterwards these managers reported to ramon alifonso alcon p r ’s director of manufacturing who reported to lee hansen alcon p r ’s general manager for its manufacturing_facility alcon p r had a quality assurance department at its manufacturing_facility and employed in that department a director and a staff of approximately to the director maria santiago reported to alcon labs’ quality assurance director in --- - fort worth texas alcon p r was responsible for the guality of avitene and its employees in its quality assurance department performed each of the required tests as set forth in the product specifications owned by medchem u s a alcon p r kept in its guality assurance department all master documentation for the manufacturing of avitene and all related records such as inspection documents charts and forms after alcon p r completed its guality assurance tests and document review it used its regular carrier to ship the packaged avitene to medchem u s a in woburn where medchem u s a stored the avitene ina warehouse or quarantine cage awaiting distribution to its customers e the end users medchem u s a performed secondary quality tests on the finished avitene product at its guality assurance department in woburn medchem p r did not have a quality assurance department and it never tested avitene for guality compliance medchem u s a prepared and filed all applications reports and other documents required by the fda to manufacture avitene alcon p r provided medchem u s a with information relating to the manufacturing process and medchem u s a incorporated that information into its fda filings medchem p r did not submit any applications reports or other documents to the fda medchem u s a ’s filings with the fda for the period date to date identified alcon p r as avitene’s -- - manufacturer medchem u s a also reported to the sec for most of and each of the relevant years thereafter that alcon p r was avitene’s manufacturer and that alcon p r manufactured avitene at its puerto rico facility for medchem u s a medchem p r did not have a facility registered with the fda to manufacture pharmaceuticals alcon p r ’s manufacturing_facility was so registered and the fda performed a yearlong inspection of that facility beginning in date during the inspection the fda dealt almost exclusively with employees of alcon p r contacts with non-alcon p r personnel were minimal and insignificant the fda’s report on the inspection listed alcon p r as avitene’s manufacturer medchem u s a had a department in woburn where its employees researched and developed avitene during the subject years for example medchem u s a researched and developed a new form of avitene named endo-avitene which it began shipping in date ariel ferdman generally directed medchem u s a ’ss research_and_development activities out of woburn and he was assisted in his work by medchem u s a employees and or alcon p r employees on a few occasions from through dr ferdman occasionally accompanied by other medchem u s a employees traveled to alcon p r ’s manufacturing_facility in puerto rico to research and develop avitene dr ferdman’s research_and_development work at alcon p r ’s manufacturing - - facility related primarily to preparing validation studies to obtain approval of an application that medchem u s a had made to the fda for endo-avitene dr ferdman also worked at the alcon p r facility from april through date studying and learning avitene’s manufacturing process so that medchem u s a could later in that year move that process into and implement that process in medchem u s a ’s woburn facility medchem p r did not have a research_and_development function and it played no part in the development of new avitene or the development of other products kelly provided temporary labor to alcon p r at its facilities from date through date pursuant to their written_agreement stating in relevant part that the kelly assigned employees are the employees of kelly and none of said persons assigned under this contract shall be regarded as employees of the buyers of the services neither petitioner was involved with that or any other agreement concerning temporary labor to be provided at the alcon p r facility as relevant herein kelly charged alcon p r dollar_figure per hour for_the_use_of a kelly employee and included in this rate the cost of kelly’s obligation to pay its employees’ workers’ compensation_unemployment insurance and social_security_taxes kelly supplied alcon p r with two of the three people who worked at the alcon p r facility from date through august - as the avitene planner buyer ’ the planner buyer generally established periodic schedules under which alcon p r manufactured avitene for medchem p r in accordance with orders placed by medchem u s a the planner buyer also attended weekly manufacturing meetings held with alcon p r managers at alcon p r ’s facility monitored the inventories of materials used in the manufacturing process purchased materials and components exclusive of corium through alcon p r ’s purchasing system after receiving the authorization of an alcon p r manager and sometimes also a medchem u s a manager dealt with alcon p r or medchem u s a personnel to cure problems arising mainly from the materials used in the avitene manufacturing process and verified with alcon p r personnel that the required quality assurance tests had been performed and confirmed that the product was ready for shipping raymond castro was a kelly employee who worked as planner buyer from on or about date through date kelly hired him and paid him dollar_figure per hour neither petitioner was involved in his hiring or in his placement as planner buyer he reported to ronald shepherd and or luis diaz an alcon p r manager and mr castro’s work required that he interact with alcon p r employees and medchem u s a employees alcon p r invoiced medchem p r for the amount that it paid kelly as to mr before this time mr perez was the planner buyer - - castro and medchem p r accounted for its payment of these invoices as an expense for outside services for office support mr castro’s status as a kelly employee ceased in date when he was hired by alcon p r as a full-time_employee mr castro continued to work on avitene matters after he was hired by alcon p r and he continued to interact with other alcon p r employees and with medchem u s a employees nelson velez succeeded mr castro as planner buyer from date through date mr velez was a longtime alcon p r employee and neither petitioner was involved in his selection or placement as planner buyer mr diaz who was mr velez’s superior assigned mr velez to serve concurrently as the planner buyer of both avitene and an unrelated alcon p r product mr velez divided his work equally between the two functions and alcon p r invoiced medchem p r for percent of his salary medchem p r accounted for its payment of these invoices as an expense for outside services for office support mr castro’s avitene-related work required that he interact with alcon p r employees and medchem u s a employees luis rivera was a kelly employee who succeeded mr velez as planner buyer from date to date kelly hired him and paid him dollar_figure per hour neither petitioner was involved in his hiring or with his placement as planner buyer mr rivera reported to mr shepherd and or various alcon p r managers and - - mr rivera’s work required that he interact with alcon p r employees and with medchem u s a employees alcon p r invoiced medchem p r for the amount that it paid kelly for mr rivera’s services and medchem p r accounted for its payment of these invoices as an expense for outside services for office support mr rivera’s status as a kelly employee ceased on date when he was retained by medchem p r as an independent consultant mr sullivan supervised medchem u s a ’s amvisc operation through he was listed as a medchem p r director on its corporate records but he never performed any duties as a medchem p r director he performed as a medchem u s a officer the following ancillary activities relating to avitene he prepared and maintained schedules listing medchem u s a ’s requirements for avitene for specified periods during the year he forwarded those schedules to mr shepherd to deliver or sometimes he delivered them himself to alcon p r and to the planner buyer he reviewed the results of the quality assurance tests which were prepared by and received from alcon p r and he monitored the sales of avitene to customers he did not attend the weekly manufacturing meetings held with alcon p r managers at alcon p r ’s facility medchem p r maintained a checking account in puerto rico through date medchem p r used that account to -- p7 - pay the routine operating_expenses eg office rent supplies of its humacao office on date medchem p r opened a checking account in california california account listing as its address medchem u s a ’s address in woburn alcon p r sent its invoices under the processing agreement to medchem u s a ’s woburn address and medchem u s a ’s personnel reviewed those invoices authorized their payment and paid them out of the california account vendors also sent their invoices for raw materials and components among other things to medchem u s a ’s woburn address where after date medchem u s a personnel reviewed and paid those invoices out of the california account sean moran and or john mcdonough signed the checks payable to vendors drawn on the california account mr moran who reported to mr donaldson spent approximately percent of his time on avitene financial matters ’ for its fiscal_year ended on date medchem p r elected under sec_936 to allocate between itself and medchem u s a the avitene-related costs including the salary expense of medchem u s a employees medchem p r ’s audited financial statements for that year reported petitioners’ calculation of percent of the total avitene product line cost of sales and selling general and administrative expenses daniel geffken also reported to mr donaldson mr geffken spent less than percent of his time on avitene-related matters - - those statements indicate that cost_of_goods_sold of dollar_figure and selling general and administrative expenses including the salary expense of medchem u s a employees working on avitene matters of dollar_figure incurred by medchem u s a were charged to medchem p r on its federal_income_tax return for that year medchem p r reported taxable_income of dollar_figure and direct_labor_costs of dollar_figure medchem p r claimed a dollar_figure tax_credit under sec_936 discussion the parties dispute whether medchem p r may calculate its federal_income_tax liability by using the puerto rico and possession_tax_credit possession_tax_credit provided under sec_936 a domestic corporate taxpayer such as medchem p r qualifies for this credit if it meets the following statutory requirements sec_936 puerto rico and possession_tax_credit a allowance of credit -- in general --except as otherwise provided in this section if a domestic_corporation elects the application of this section and if the conditions of both subparagraph a and subparagraph b of paragraph are satisfied there shall be allowed as a credit against the tax imposed by this chapter an amount equal to the portion of the tax which is attributable to the sum of--- a the taxable_income_from_sources_without_the_united_states from- - - the active_conduct_of_a_trade_or_business within a possession_of_the_united_states or 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 conditions which must be satisfied - -the conditions referred to in paragraph are a 3-year period --if percent or more of the gross_income of such domestic_corporation for the 3-year period immediately preceding the close of the taxable_year or for such part of such period immediately preceding the close of such taxable_year as may be applicable was derived from sources within a possession_of_the_united_states determined without regard to sec_904 and b trade_or_business --if 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 respondent determined and contends that none of medchem p r ’s taxable_income for its fiscal_year ended date -- - qualifies for the possession_tax_credit ' respondent argues primarily that medchem p r did not meet the active_conduct_of_a_trade_or_business requirement of sec_936 b petitioners contend that all of medchem p r ’s taxable_income qualifies for the possession_tax_credit petitioners argue that medchem p r met the active_conduct_of_a_trade_or_business requirement because petitioners assert all of medchem p r ’s income was derived from its sales in puerto rico of avitene that it manufactured in puerto rico petitioners assert that in addition to that sales income medchem p r had significant business activities in puerto rico petitioners assert that medchem p r ’s business activities in puerto rico included purchasing the raw materials necessary for avitene monitoring manufacturing and inventory levels of avitene and owning all of the manufacturing equipment raw materials work-in-process and finished goods related to avitene petitioners assert that medchem p r performed its business activities in puerto rico through its common_law employees consisting of its officers the kelly employees and employees who worked concurrently for medchem p r and either medchem u s a or alcon p r petitioners assert that medchem p r also performed significant business ‘as an alternative to this determination respondent determined that medchem p r ’s income was taxable to the medchem group under sec_482 because respondent does not pursue this argument on brief we consider it conceded --- - activities in puerto rico through alcon p r a contract manufacturer petitioners argue that activities performed through a contract manufacturer such as alcon p r are imputed to the other party to the contract in this case medchem p r we agree with respondent that medchem p r does not qualify for the possession_tax_credit because it failed the active_conduct_of_a_trade_or_business requirement of sec_936 b as we read sec_936 a domestic corporate taxpayer may elect to determine its federal_income_tax liability by using the possession_tax_credit if it meets two requirements the credit equals the amount of tax attributable to the sum of the taxpayer’s qualified possession-source investment_income plus the taxpayer’s non-u s -source income that it earned from its active_conduct_of_a_trade_or_business in a u s possession or its sale_or_exchange of substantially_all of the assets used in the active_conduct of that trade_or_business the two requirements are the 80-percent test of sec_936 a and the 75-percent test of sec_936 b we concern ourselves only with the 75-percent test of sec_936 b because the parties agree that medchem p r has met the percent test under the 75-percent test medchem p r qualified for the possession_tax_credit if at least percent of its gross_income for the 3-year period ended date was derived - - from its active_conduct_of_a_trade_or_business within puerto rico we are unable to find that such was the case medchem p r did not actively conduct a trade_or_business within puerto rico throughout the 3-year period whether medchem p r actively conducted such a trade_or_business is a highly fact intensive issue as to which petitioners bear the burden_of_proof cf 312_us_212 308_us_488 290_us_111 187_f3d_203 lst cir because congress has not explicitly defined the phrase active_conduct_of_a_trade_or_business for purposes of sec_936 or for that matter for any other purpose of the code congress has essentially left it to the secretary to define that phrase by way of regulations or in the absence of regulations to the courts to construe the phrase by way of judicial interpretation as the supreme court observed in construing the phrase trade_or_business for purposes of sec_162 a the phrase trade_or_business has been in sec_162 and in that section’s predecessors for many years indeed the phrase is common in the code for it appears in over sections and subsections and in hundreds of places in proposed and final income_tax regulations the slightly longer phrases carrying_on_a_trade_or_business and engaging in a trade_or_business themselves are used no less than times in the code the concept thus has a well-known and almost constant presence on our tax-law terrain despite - - this the code has never contained a definition of the words trade_or_business for general application and no regulation has been issued expounding its meaning for all purposes neither has a broadly applicable authoritative judicial definition emerged our task in this case is to ascertain the meaning of the phrase as it appears in the sections of the code with which we are here concerned 480_us_23 fn refs omitted given the lack of a statutory or regulatory definition of the phrase active_conduct_of_a_trade_or_business as used in sec_936 we believe it appropriate to construe that phrase by reference to the secretary’s definitions of the phrase for other purposes of the code bearing in mind congress’ intent in enacting sec_936 as reflected in its legislative_history cf 110_tc_189 court interpreted the subject phrase for purposes of sec_355 by reference to the definition set forth in the regulations prescribed under sec_355 our research reveals that the phrase active_conduct_of_a_trade_or_business appear sec_22 times in the current version of the internal revenue code’ and that the secretary has issued extensive regulations interpreting that phrase in three of those sections first for of course we also bear in mind the supreme court’s interpretation of the phrase trade_or_business as espoused in 480_us_23 to wit an activity in which a taxpayer is involved with continuity regularity and a profit--motivated primary purpose see sec_30a sec_49 sec_168 sec_179 sec_351 sec_355 sec_367 sec_407 sec_543 sec_731 sec_806 sec_861 sec_865 sec_936 sec_954 sec_957 sec_995 sec_1202 sec_1298 sec_1362 sec_2057 sec_4001 - - purposes of sec_179 the secretary prescribed in sec_1_179-2 income_tax regs the following relevant rules as to the meaning of the phrase active_conduct by the taxpayer of a trade or business--- i trade_or_business for purposes of this section and sec_1_179-4 the term trade_or_business has the same meaning as in sec_162 and the regulations thereunder active_conduct for purposes of this section the determination of whether a trade_or_business is actively conducted by the taxpayer is to be made from all the facts and circumstances and is to be applied in light of the purpose of the active_conduct requirement of sec_179 a in the context of sec_179 the purpose of the active_conduct requirement is to prevent a passive investor in a trade_or_business from deducting sec_179 expenses against taxable_income derived from that trade_or_business consistent with this purpose a taxpayer generally is considered to actively conduct a trade_or_business if the taxpayer meaningfully participates in the management or operations of the trade_or_business a mere passive investor in a trade_or_business does not actively conduct the trade_or_business second for purposes of sec_355 the secretary prescribed in sec_1_355-3 income_tax regs the following relevant rules as to the phrase’s meaning active_conduct_of_a_trade_or_business immediately after distribution-- i in general for purposes of sec_355 a corporation shall be treated as engaged in the active_conduct_of_a_trade_or_business immediately after the distribution if the assets and activities of the corporation satisfy the requirements and limitations described in paragraph bo and iv of this section trade_or_business a corporation shall be treated as engaged in a trade_or_business immediately after the distribution if a specific group of activities are being carried on by the corporation -- - for the purpose of earning income or profit and the activities included in such group include every operation that forms a part of or a step in the process of earning income or profit such group of activities ordinarily must include the collection of income and the payment of expenses active_conduct for purposes of sec_355 the determination whether a trade_or_business is actively conducted will be made from all of the facts and circumstances generally the corporation is required itself to perform active and substantial management and operational functions generally activities performed by the corporation itself do not include activities performed by persons outside the corporation including independent contractors a corporation may satisfy the requirements of this subdivision through the activities that it performs itself even though some of its activities are performed by others iv limitations the active_conduct_of_a_trade_or_business does not include- a the holding for investment purposes of stock securities land or other_property or b the ownership and operation including leasing of real or personal_property used in a trade_or_business unless the owner performs significant services with respect to the operation and management of the property third for purposes of sec_367 the secretary prescribed in sec_1_367_a_-2t b temporary income_tax regs fed reg date the following relevant rules as to the phrase’s meaning b active_conduct_of_a_trade_or_business outside the united states-- in general property qualifies for the exception provided by this section if it is transferred to a foreign_corporation for use in the active_conduct_of_a_trade_or_business outside of the united_states therefore to determine whether - - property is subject_to the exception provided by this section four factual determinations must be made what is the trade_or_business of the transferee do the activities of the transferee constitute the active_conduct of that trade_or_business i111 is the trade_or_business conducted outside of the united_states and iv is the transferred property used or held for use in the trade_or_business rules concerning these four determinations are provided in paragraph b and of this section trade_or_business whether the activities of a foreign_corporation constitute a trade_or_business must be determined under all the facts and circumstances in general a trade_or_business is a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit for example the activities of a foreign selling subsidiary could constitute a trade_or_business if they could be independently carried on for profit even though the subsidiary acts exclusively on behalf of and has operations fully integrated with its parent_corporation to constitute a trade_or_business a group of activities must ordinarily include every operation which forms a part of or a step in a process by which an enterprise may earn income or profit in this regard one or more of such activities may be carried on by independent contractors under the direct control of the foreign_corporation however see paragraph b of this section the group of activities must ordinarily include the collection of income and the payment of expenses if the activities of a foreign_corporation do not constitute a trade_or_business then the exception provided by this section does not apply regardless of the level of activities carried on by the corporation -- - active_conduct whether a trade_or_business is actively conducted must be determined under all the facts and circumstances in general a corporation actively conducts a trade_or_business only if the officers and employees of the corporation carry out substantial managerial and operational activities a corporation may be engaged in the active_conduct_of_a_trade_or_business even though incidental activities of the trade_or_business are carried out on behalf of the corporation by independent contractors in determining whether the officers and employees of the corporation carry out substantial managerial and operational activities however the activities of independent contractors shall be disregarded on the other hand the officers and employees of the corporation are considered to include the officers and employees of related entities who are made available to and supervised on a day-to-day basis by and whose salaries are paid_by or reimbursed to the lending related_entity by the transferee foreign_corporation the rule_of this paragraph b is illustrated by the following example example xx a domestic_corporation and y a foreign_corporation not related to x transfer property to z a newly formed foreign_corporation organized for the purpose of combining the research activities of x and y 2z contracts all of its operational and research activities to y for an arm’s-length fee 2z2’s activities do not constitute the active_conduct_of_a_trade_or_business outside of the united_states whether a foreign_corporation conducts a trade_or_business outside of the united_states must be determined under all the facts and circumstances generally the primary managerial and operational activities of the trade_or_business must be conducted outside the united_states and immediately_after_the_transfer the transferred assets must be located outside the united_states thus the exception provided by this section would not apply to the transfer of the assets of a domestic business to a foreign_corporation if the domestic business continued to operate in the united_states after the transfer in such a case the primary operational activities of the business would continue to be conducted in the united_states moreover the transferred assets would be located in the united -- - states however it is not necessary that every item of property transferred be used outside of the united_states as long as the primary managerial and operational activities of the trade_or_business are conducted outside of the united_states and substantially_all of the transferred assets are located outside the united_states incidental items of transferred property located in the united_states may be considered to have been transferred for use in the active_conduct_of_a_trade_or_business outside of the united_states use in the trade_or_business whether property is used or held for use in a trade_or_business must be determined under all the facts and circumstances in general property is used or held for use in a foreign corporation’s trade_or_business if it is-- held for the principal purpose of promoting the present conduct of the trade_or_business acquired and held in the ordinary course of the trade_or_business or otherwise held in a direct relationship to the trade_or_business as to congress’ intent for sec_936 the roots of that section are found in sec_262 of the revenue act of ch 42_stat_271 which exempted a u s_corporation from federal taxes on foreign-source income if it derived at least percent of its income from sources within a u s possession and satisfied certain other requirements the requirements for exemption from tax as a possession_corporation were generally carried forward into sec_931 of the internal_revenue_code of congress promulgated sec_931 and its predecessors to encourage american businesses to invest in u s possessions see 88_tc_252 see also 106_tc_1 american companies operating in the possessions were originally subjected to double_taxation in the form of the federal corporate_income_tax and the taxes of the possessions see tariff act of ch sec ii 38_stat_166 revenue act of ch 40_stat_1057 congress perceived that this double tax burden placed american businesses at a competitive disadvantage when compared with their british and french counterparts which were not subject_to taxation upon the profits they earned abroad unless paid back to the home company congress enacted sec_931 to remove that competitive disadvantage see h rept 67th cong 1st sess c b part in its original form sec_931 allowed a corporation to exclude its possession-source income if it met an 80-percent source test and a 50-percent active trade_or_business test because of the exclusion and because dividends received by a domestic_corporation from its wholly owned possessions subsidiary were not eligible for the intercorporate dividends received deductions under sec_246 b possessions_corporations amassed large amounts of income not repatriated to the united_states in the tax reform act of publaw_94_455 90_stat_1643 congress revised the prior_law in order to provide -- - for a more efficient system exempting possessions_corporations so that the possessions would not lose a significant source of capital see coca-cola co subs v commissioner supra pincite in place of the exemption mechanism contained in sec_931 congress enacted sec_936 to permit a u s_corporation to elect a tax_credit to offset the u s tax on its possessions income thus the current version of the investment incentive takes the form of a tax_credit rather than an exemption it is clear from the legislative record that congress was aware of the highly favorable tax benefits afforded u s_corporations operating in puerto rico it is equally clear that congress intended to retain and reaffirm such tax benefits by enacting sec_936 the senate_finance_committee and the house ways_and_means_committee stated the following in virtually identical reports the special exemption provided under sec_931 in conjunction with investment incentive programs established by possessions of the united_states especially the commonwealth of puerto rico have been used as an inducement to u s corporate investment in active trades and businesses in puerto rico and the possessions under these investment programs little or no tax is paid to the possessions for a period as long as to years and no tax is paid to the united_states as long as no dividends are paid to the parent_corporation because no current u s tax is imposed on the earnings if they are not repatriated the amount of income which accumulates over the years from these business activities can be substantial the amounts which may be allowed to accumulate are often beyond what can be profitably invested within the possession - al --- where the business is conducted as a result corporations generally invest this income in other possessions or in foreign countries either directly or through possessions banks or other financial institutions in this way possessions_corporations not only avoid u s tax on their earnings from businesses conducted in a possession but also avoid u s tax on the income obtained from reinvesting their business earnings abroad the committee after studying the problem concluded that it is inappropriate to disturb the existing relationship between the possessions investment incentives and the u s tax laws because of the important role it is believed they play in keeping investment in the possessions competitive with investment in neighboring countries the u s government imposes upon the possessions various requirements such as minimum wage requirements and requirements to use u s flagships in transporting goods between the united_states and various possessions which substantially increase the labor transportation and other costs of establishing business operations in puerto rico thus without significant local_tax incentives that are not nullified by u s taxes the possessions would find it quite difficult to attract investments by u s_corporations however investing the business earnings_of these possession corporations outside of the possession where the business is being conducted does not contribute significantly to the economy of that possession either by creating new jobs or by providing capital to others to build new plants and equipment accordingly while the committee believes it is appropriate to continue to exempt trade_or_business income derived in a possession and investment_income earned in that possession your committee does not believe it 1s appropriate to provide a tax exemption for income from investments outside of the possession in addition the committee recognizes that the provision of present law denying a dividends received deduction to the u s parent_corporation forces a possessions_corporation to invest its income abroad until the possessions_corporation is liquidated usually upon the termination of the local_tax exemption when it can be returned to the united_states - -- tax free these accumulated business profits are not available for investment within the united_states and the income produced is under present law not subject_to u s tax the committee believes that while it is appropriate to tax the foreign source investment_income from possession business earnings possessions_corporations should at the same time be given the alternative of returning the business income to the united_states prior to liguidation without paying u s tax permitting tax-free repatriation of the accumulated earnings only upon the liquidation of the possessions_corporation while taxing the foreign source investment derived from the accumulated earnings would lessen to a significant extent the tax incentive of making the initial investment to accomplish these two major changes the committee’s amendment revises present law to provide for a more efficient system for exemption of possessions_corporations under the amendment these corporations are generally to be taxed on worldwide income in a manner similar to that applicable to any other u s_corporation but a full percent foreign_tax_credit is to be given for the business and qualified_investment_income from possessions regardless of whether or not any_tax is in fact paid to the government of the possession the effect of this revised treatment will be to exempt from tax the income from business activities and qualified_investments in the possessions to allow a dividends received deduction for dividends from a possessions_corporation to its u s parent_corporation and to tax currently all other foreign_source_income of possessions_corporations with allowance for the usual foreign_tax_credit the committee believes that this revised treatment will 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 s rept pincite 1976_3_cb_57 fn refs omitted see also h rept pincite 1976_3_cb_945 -- - on the basis of our understanding of the legislative record we believe that congress promulgated the active_conduct_of_a_trade_or_business requirement of sec_936 intending to prevent a domestic corporate taxpayer from availing itself of the possessions tax_credit unless it established and regularly operated an employment-producing profit--motivated business activity inau s possession we also believe that congress expected the taxpayer to participate meaningfully in the management and operation of that activity and to invest significantly in that activity the expected result of which would be to strengthen the economy of the possession where the activity was located in light of congress’ intent for sec_936 the secretary’s interpretations of the subject phrase for purposes of other sections of the code and the supreme court’s interpretation of the phrase trade_or_business in sec_162 we believe that for purposes of sec_936 a taxpayer actively conducts a trade_or_business ina u s possession only if it participates regularly continually extensively and actively in the management and operation of its profit--motivated activity in that possession cf commissioner v groetzinger u s pincite higgins v commissioner u s pincite 399_f2d_326 5th cir affg tcmemo_1967_137 we also believe that for the purpose of this participation requirement the services - underlying a manufacturing contract may be imputed to a taxpayer only to the extent that the performance of those services is adequately supervised by the taxpayer’s own employees we ask ourselves in this case whether medchem p r participated regularly continually extensively and actively in the management and operation of avitene’s manufacturing in puerto rico throughout the requisite 3-year period under the facts at hand we must answer that question in the negative indeed we are not even able to find that medchem p r had any meaningful business activity in puerto rico during that period medchem p r ’s investment in the economy of puerto rico during that period was almost nonexistent in the sense that it placed in that possession only one employee and established in that possession only a one-room office moreover medchem p r abandoned the office and terminated the employee on date although medchem p r ’s decision to have avitene manufactured in puerto rico did result in the use of some of that possession’s work force and thus ostensibly harmonize with congress’ intent for the possessions tax_credit to produce employment in that possession we are unable to find that more than a few if any of the individuals who worked in puerto rico on avitene-related matters were hired as a result of the avitene contract all the same we do not believe that the creation of jobs in puerto rico - -- is the sole criterion that a taxpayer must meet in order to be entitled to the possession_tax_credit petitioners observe correctly that medchem p r was involved with the puerto rico-based manufacturing business of avitene by virtue of the fact that it supplied the raw materials and equipment necessary to manufacture the drug such minimal association with a trade_or_business however does not constitute the active_conduct_of_a_trade_or_business in puerto rico for purposes of sec_936 the mere fact that a taxpayer owns property used in a trade_or_business is simply not enough to characterize the taxpayer as an active conductor of that trade_or_business the taxpayer in such a situation does not meet the requirement as to a regular continual extensive and active_participant in the management and operation of the profit--motivated activity nor in fact does such a taxpayer subject itself to many of the economic risks and benefits of business in general here medchem p r lacked any operational or directional control_over the avitene business all of the business activities connected to avitene were directed and controlled by alcon p r out of its puerto rico-based operation and by medchem u s a out of its woburn-based facility in fact petitioners’ involvement in puerto rico during the 3-year period failed even to qualify as a trade_or_business in puerto rico -- - given that petitioners’ involvement in that possession focused mainly on the woburn-based efforts of medchem u s a ’s personnel to understand the avitene manufacturing process and after date to move that process from alcon p r ’s facility in puerto rico to medchem u s a ’s facility in woburn whereas petitioners initially planned to establish a manufacturing_facility in puerto rico during the relevant years and to that end hired mr perez opened an office in humacao and purchased land in juncos their plans changed in in petitioners scuttled their efforts to establish a facility in puerto rico wrote off the proposed facility’s capitalized costs closed the humacao office terminated mr perez and began moving the avitene manufacturing process into medchem u s a ’s idled amvisc facility in woburn petitioners also caused alcon p r to move into that facility all of the equipment in puerto rico that had been and was required to be used to perform the work in phase of the avitene manufacturing process petitioners assert that all of medchem p r ’s income was attributable to its sale in puerto rico of avitene that was manufactured in that possession and that medchem p r had a significant_business_presence in puerto rico we disagree we distinguish 308_f2d_520 9th cir a case cited by petitioners to support their assertion that medchem p r actively conducted a trade_or_business by virtue of its sales activity the relevant holding continued a7 - for purposes of sec_936 medchem p r ’s business presence in puerto rico was insignificant in that it did not contribute significantly to puerto rico’s economy either by creating new jobs or by providing capital to others to build new plants and equipment see s rept supra pincite c b vol pincite see also h rept supra c b vol pincite all of medchem p r ’s business activities after date were based in woburn and petitioners’ primary connection to puerto rico during that time was to further its efforts to move the manufacturing of avitene to woburn where the nonmanufacturing avitene-related business and ancillary activities eg financial oversight sales and product development were performed by medchem u s a employees petitioners rely on the fact that title to the non-japanese- market avitene passed from medchem p r to medchem u s a in puerto rico we do not believe that this fact standing alone leads to petitioners’ proffered conclusion that medchem p r actively conducted a trade_or_business in puerto rico throughout the 3-year period indeed the facts of this case leads us to a contrary conclusion avitene was manufactured in puerto rico m4 continued in frank concerned whether the taxpayer actively conducted a trade_or_business and did not concern where that trade_or_business was located ‘ petitioners rely in part on their assertion in brief that continued -- - at the alcon p r facility and alcon p r ’s employees performed every task required in the manufacturing process including the supervision thereof alcon p r ’s employees performed those jobs without the right or ability of either petitioner to manage direct or control any part of the manufacturing process alcon p r employees also performed avitene’s quality assurance function including the retention of avitene’s master documentation and manufacturing records ’ medchem u s a ’s employees distributed marketed and sold avitene from woburn and they did so without any interaction or involvement by medchem p r medchem u s a ’s employees worked out of woburn improving avitene and developing new forms of avitene medchem u s a ’s woburn-based personnel maintained for petitioners the books_and_records as to avitene and received reviewed and processed payment on any avitene-related invoice received by petitioners medchem u s a ’s personnel provided alcon p r and the planner buyers with manufacturing schedules prepared in woburn continued the parties have stipulated that percent of medchem p r ’s income was derived from its sales in puerto rico of avitene that was manufactured in puerto rico actually the stipulation reads that percent of medchem p r ’s reported income came from the sale of avitene that was manufactured in puerto rico the stipulation does not say that medchem p r sold the avitene in puerto rico ‘ although medchem u s a occasionally performed limited guality assurance tests on finished avitene medchem p r performed no guality testing at all --- - the planner buyers who were employed at the alcon p r facility by kelly or alcon p r made sure that alcon p r ’s personnel had the materials necessary to manufacture avitene medchem u s a owned all of the intangible assets used to manufacture avitene and throughout the 3-year period guaranteed to the alcon entities that it would pay all debts and perform all obligations of medchem p r arising from the asset purchase and related agreements petitioners list in their brief activities which they assert demonstrate that medchem p r actively conducted a trade_or_business in puerto rico during the requisite 3-year period we disagree with this assertion some of the activities listed by petitioners preceded the 3-year period and very few of the other listed activities occurred continually throughout that period the isolated activities which did occur during the period do not support petitioners’ conclusion that medchem p r continued to conduct actively a trade_or_business in puerto rico the mere fact that medchem p r owned the necessary raw materials and manufacturing equipment and hired alcon p r to use those materials and equipment to manufacture avitene in puerto rico is not enough under the facts herein to conclude that medchem p r actively conducted a trade_or_business in puerto rico throughout -- - the 3-year period ’ while it is true that petitioners continued to use the trade_or_business of alcon p r to manufacture avitene after date while medchem u s a established an avitene manufacturing_facility in woburn the use of alcon p r ’ss business was not medchem p r ’s trade_or_business in fact petitioners have consistently reported in all but one instance that alcon p r was avitene’s manufacturer that one instance is here where solely for the purpose of federal_income_tax petitioners invite the court to hold that medchem p r was in fact avitene’s manufacturer we decline that invitation petitioners argue that medchem p r had employees who performed avitene-related services in puerto rico during the year period petitioners assert that medchem p r paid for the avitene-related services of these individuals and that the individuals represented the interests of medchem p r while working on avitene matters petitioners assert that medchem p r directed and controlled the avitene-related work of these individuals and that no non-medchem p r employee or entity had the ability to direct or control that work petitioners generally identify these individuals as the medchem p r officers ‘7 contrary to petitioners’ request we do not find that medchem p r employees purchased those raw materials or monitored the production of avitene or any of the inventory as discussed herein employees of either alcon p r or medchem u s a generally performed all of the services connected to avitene during the 3-year period - and or directors the kelly employees certain medchem u s a employees and a certain alcon p r employee petitioners assert that individuals in the latter two categories worked concurrently as employees of medchem p r and either medchem u s a or alcon p r petitioners specifically identify these individuals as mr perez and his staff from date through date messrs castro and rivera from date through date and from april through date messrs castro and velez from date through date medchem p r officers and or directors donaldson geffken moran sullivan and swann medchem u s a employees acosta falvey ferdman micale mcdonough rudolph severance shepherd stevens and tanny and various unnamed engineers we do not find that any of the listed individuals were medchem p r employees the presence of an employer-employee relationship is a factual determination that rests on the principles of common_law see eg 503_us_318 92_tc_351 affd 907_f2d_1173 d c cir professional executive leasing inc v commissioner t1t c affd 862_f2d_751 9th cir 64_tc_974 see also sec_3121 factors commonly considered by courts in determining such a relationship are the right to control the details of - - the work furnishing of the tools and the work place withholding of taxes workers’ compensation and unemployment insurance funds right to discharge and permanency of the relationship see professional executive leasing inc v commissioner f 2d pincite citing 331_us_704 simpson v commissioner supra pincite although each factor is important the test that is usually considered fundamental is set out in the regulations sec_31_3401_c_-1 employment_tax regs which generally sets forth rules as to an employer’s obligation to withhold federal income taxes on the payment of wages provides generally the relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services not only as to the result to be accomplished by the work but also as to the details and means by which that result 1s accomplished that is an employee is subject_to the will and control of the employer not only as to what shall be done but how it shall be done in this connection it is not necessary that the employer actually direct or control the manner in which the services are performed it is sufficient if he has the right to do so x in general if an individual is subject_to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result he is not an employee see also sec_31_3121_d_-1 and -1 b employment_tax regs providing language virtually identical to sec_31 c -1 b employment_tax regs in the case of the federal_insurance_contributions_act and the federal_unemployment_tax_act respectively -- - here we find nothing in the record to persuade us that medchem p r had the right to direct or control any of the purported medchem p r employees in their performance of avitene- related_services although petitioners invite us to find that medchem p r directed and controlled the avitene-related work of these individuals by virtue of the fact that they interacted with one or more individuals who served concurrently as an officer and or director of medchem p r and medchem u s a the record indicates to the contrary all of the individuals who worked on an avitene matter were directed and controlled by either alcon p r or medchem u s a in fact medchem p r was expressly prohibited by the processing agreement from taking a managerial role in the manufacturing process moreover medchem p r never even directed or controlled any of its officers except possibly mr perez up until date we also believe it most telling that medchem p r did not hold any of these individuals out or report them as employees until the commencement of this litigation that each of these individuals was hired and directly paid_by medchem u s a or alcon p r that medchem p r never paid employment_taxes as to these individuals that medchem p r never provided these individuals with workers’ compensation insurance or employee_benefits and that all of these individuals worked at the alcon p r and medchem u s a facilities - - we conclude and hold that medchem p r does not meet the active_conduct_of_a_trade_or_business within a possession requirement of sec_936 b in so holding we note that petitioners rely erroneously on 114_tc_1 for a contrary holding there the taxpayer was a corporation that sold greeting cards and other paper products bearing copies of one or more of the taxpayer’s cartoon characters the taxpayer’s employees developed the characters and the taxpayer transferred the characters to printing companies to print the paper products in accordance with the taxpayer’s specifications the printers used their own ink and paperstock and they held title to and bore the risk of loss of the supplies and printed goods until the goods were sent back to the taxpayer for its acceptance or rejection the printers could not sell any images of the characters and they could not sell any of the taxpayer’s paper products the taxpayer argued that for purposes of sec_263a the printers produced the finished goods and it resold them we disagreed we held that the taxpayer was the producer of the finished goods we noted that the printing of the characters onto the paper products was ministerial and that the critical step in the manufacturing of the finished good was the drawing of the characters in contrast with the situation there where the thrust of the work as to the finished product was performed by the taxpayer the thrust of the -- - work here as to the manufacturing of avitene was performed by alcon p r the avitene manufacturing process was not ministerial but required specialized skill and expertise unlike the reproduction process in suzy’s zoo we have rejected all arguments not discussed herein as without merit or irrelevant to reflect the foregoing decisions will be entered under rule pre-sec dec feb june sec a b -- - appendix a a b test period to date petitioners buy the avitene business from alcon p r and alcon p r agrees to and ultimately does manufacture avitene for medchem p r for the 3-year period ended date medchem p r hires mr perez and establishes a one-room office in humacao medchem p r purchases land for the construction of an avitene manufacturing_facility in puerto rico test period date to date feb feb june date district_court issues preliminary injunction as to medchem u s a ’s manufacture and sale of amvisc medchem p r writes off capitalized expenses relating to its proposed facility in puerto rico unipro notified to stop work on that facility medchem u s a initiates plans to locate an avitene manufacturing_facility into its idled amvisc facility in woburn during the fall of petitioners move their bulk flour manufacturing equipment from humacao to woburn mr perez terminated humacao office closed and records shipped to woburn kelly hires mr castro to replace mr perez as avitene planner buyer medchem u s a personnel in woburn write all medchem p r checks and mail those checks to the payees medchem u s a ’s personnel in woburn approve and pay from medchem p r bank account all invoices delivered to medchem p r date date date date -- - petitioners move their bulk nonwoven web manufacturing equipment from humacao to woburn mr castro becomes alcon p r employee with non-avitene duties and alcon p r assigns mr velez to perform mr castro’s former duties kelly hires mr rivera to replace mr velez as avitene planner buyer fda audits the avitene manufacturing process and deals almost exclusively with alcon p r personnel post- sec_936 b period date to date date date date medchem u s a starts manufacturing avitene in woburn medchem u s a begins constructing a new avitene finished goods manufacturing_facility in woburn medchem u s a substantially completes the construction of that facility - - appendix b processing agreement processing agreement dated as of date by and between medchem puerto rico inc medchem p r a delaware corporation and alcon puerto rico inc alcon p r a delaware corporation in consideration of the mutual covenants and agreements contained in this agreement medchem p r and alcon p r covenant and agree as follows definitions as used in this agreement the following terms have the meanings set forth below acceptance tests ---- chemical physical and performance tests conducted in accordance with the analytical procedures described in a referenced schedule to be applied to avitene in order to determine whether avitene conforms to the product specifications conversion process -- the manufacturing process by which raw materials are converted into the finished avitene product delivery -- the delivery by alcon p r of avitene processed under this agreement equipment ---- the machinery and equipment owned by medchem p r and required for the processing of avitene humacao plant - alcon p r ’s avitene processing facility in humacao puerto rico dollar_figure order -- a writing from medchem p r authorizing or directing alcon p r to process and deliver avitene --- - dollar_figure product specifications -- the specifications for avitene set forth in a referenced schedule dollar_figure proprietary information --- all patents trademarks trade secrets copyrights inventions designs logos and any other proprietary rights owned by medchem p r which relate to the production and processing of avitene dollar_figure processing fee and option c processing fee --- the fees paid_by medchem p r to alcon p r for each order filled by alcon p r pursuant to section processing in general subject_to the provisions of sec_5 and in return for a processing fee as defined in section alcon p r agrees to process from raw materials owned and supplied by medchem p r all of medchem p r ’s requirements of avitene for sale by medchem p r to third parties the raw materials used in the conversion process as well as the finished avitene product will remain the sole property of medchem p r throughout alcon p r ’s physical possession thereof alcon p r agrees to commit its humacao plant for the processing of avitene to satisfy medchem p r ’s requirements subject_to the provisions of sec_5 in the event that medchem p r j ’ss requirements of avitene ever exceed the capacity of the humacao plant as of the date hereof medchem p r shall at its expense obtain such additional equipment as is necessary to increase production capacity at the humacao plant or shall use reasonable efforts to obtain access elsewhere to additional production capacity in order to meet the requirements that the humacao plant is unable to satisfy specifications alcon p r agrees to process avitene in accordance with the product specifications and good manufacturing practices as defined by applicable laws and regulations -- - processing method to assist alcon p r in satisfying its obligations under this agreement medchem p r shall grant to alcon p r pursuant to the terms of sec_4 the right to use the equipment without charge therefor alcon p r shall furnish all labor variable and fixed overhead and guality assurance required for the processing of avitene hereunder medchem p r will employ a plant manager and other appropriate personnel who will inspect advise and make corrections when appropriate with respect to the conversion process however medchem p r employees will not participate in the alcon p r management process alcon p r shall be responsible for all maintenance of the equipment used in the conversion process and for the compliance of such equipment with applicable regulations of governmental agencies including but not limited to regulations promulgated by the u s food and drug administration and the environmental protection agency the cost of such maintenance and compliance shall be borne initially by alcon p r but shall be included in the processing cost as such term is defined in section alcon p r shall also be responsible for required validation studies on devices formulae or processes used in the conversion process in the event that alcon p r 1s required by a regulatory authority to perform additional validation studies for purposes of validating new devices new manufacturing procedures and or new raw material and finished product assay procedures in order to continue lawfully to engage in the processing of avitene for medchem p r and medchem p r after notice from alcon that such additional validation studies are required directs alcon p r to continue such processing all expenses borne by alcon p r in the conduct of any such validation studies shall be paid_by alcon p r and shall be included in the processing cost to the extent that medchem p r makes direct expenditures not described in the preceding sentence with regard to a the purchase of machinery or equipment b the compliance of existing machinery or equipment with all applicable laws and regulations or c the performance of validation studies or any matter relating to the conversion process such expenditures shall not be included in the processing cost license grant medchem p r shall grant to alcon p r a royalty-free nonexclusive nontransferable license to use the proprietary information solely in connection with the processing of avitene for medchem p r pursuant to this agreement ownership title to and ownership of the proprietary information shall at all times remain solely and exclusively with medchem p r and alcon p r shall not take any_action inconsistent with such title and ownership protection alcon p r hereby covenants to hold such proprietary information in confidence alcon p r shall not without the prior written consent of medchem p r disclose or otherwise make available such proprietary information in any form to any person except to alcon p r ’s employees equitable relief indemnification since an unauthorized use or transfer of the proprietary information will substantially diminish the value to medchem p r of its rights with respect thereto if alcon p r breaches any of its obligations under this sec_3 medchem p r shall without limiting its other rights or remedies be entitled to equitable relief including but not limited to injunctive relief to protect its interests alcon p r shall indemnify and hold medchem p r harmless for any losses or damages which medchem p r may suffer as a result of any unauthorized use transfer or disclosure of the proprietary information caused by the acts or omission of alcon p r machinery and equipment for the duration of this agreement medchem p r shall grant to alcon p r the right to use free of charge all equipment owned by medchem p r and required in the conversion process provided that alcon p r shall use such equipment solely for the purpose of processing avitene pursuant to this agreement title to and ownership of the equipment shall remain at all times solely and exclusively with medchem p r alcon p r ’s rights with respect to the use of the equipment shall be nontransferable alcon p r shall take reasonable -- - precautions to preserve the physical condition of the equipment and upon the termination of this agreement pursuant to sec_12 shall return the equipment to medchem p r in good working order and in the same condition taking into account normal wear_and_tear as it was initially provided to alcon p r in the event of any damage to the equipment covered by insurance maintained by medchem p r medchem p r shall be obligated to apply any proceeds received in respect of such insurance and alcon p r shall be relieved from liability to the extent of such proceeds ordering procedure initial annual forecast medchem p r shall be responsible for directing the quantity and types of avitene processed by alcon p r in that regard medchem p r shall within days of the date of this agreement deliver to alcon p r an annual forecast the initial forecast amount of medchem p r ’s projected regquirements for each avitene product for each calendar_quarter or fraction thereof during the period commencing on the date of this agreement and ending on date subsequent annual forecast no later than date and medchem p r shall submit to alcon p r its preliminary annual forecast of its quarterly requirements of avitene for the next calendar_year the current annual forecast amount such preliminary annual forecast shall be updated on date and annual commitment medchem p r shall order at least of the initial forecast amount or the current annual forecast amount and alcon p r shall be required to process up to of the initial forecast amount or the current annual forecast amount in this regard alcon p r shall be given a reasonable amount of time to meet any increases over the initial forecast amount alcon p r agrees upon reasonable notice to act in good_faith to meet any such increases in addition in connection with medchem p r ’s efforts to establish the medchem p r plant pursuant to section alcon p r agrees upon reasonable notice to use good_faith efforts to process such reasonable amounts in excess of of the current annual forecast amount during the -- - ninety day period prior to the effective termination of this agreement so that medchem p r may maintain sufficient inventory to continue normal sales activity while it commences operation at the medchem p r plant orders and quarterly updates within a reasonable_time after the date of this agreement and at least days prior to january april july and october of each year thereafter medchem p r shall furnish to alcon p r a binding order for avitene to be processed and delivered by alcon p r on a date of delivery specified by medchem p r which will allow alcon p r at least days from the date of receipt of such order before such delivery is required and a forecast of medchem p r ’s projected requirements of avitene for the three calendar months following the calendar_quarter covered by the relevant order alcon p r shall deliver the specified quantity and type of avitene within not more than seven days after the delivery date specified in the order it is understood and agreed that in the event alcon p r is unable or unwilling through no fault of medchem p r to process avitene ordered by medchem p r in the amount forecast and or ordered medchem p r is free without thereby restricting any rights or remedies it may have against alcon p r as a result of such nonperformance hereunder to seek the contract services of third parties to process the incremental guantities which alcon p r is unable or unwilling to provide invoices alcon p r shall submit to medchem p r an invoice as soon as practicable after delivery of avitene to medchem p r such invoice shall specify the amount and type of avitene delivered pursuant to the relevant order the date of shipment and the processing cost and a calculation of the processing fee allocable to the order packaging and labeling design of package medchem p r shall be responsible for preparing and providing to alcon p r labeling copy and or artwork as appropriate for avitene and medchem p r hereby warrants that - -- such labeling shall be in content in compliance with all applicable governmental regulations in determining the labeling for avitene medchem p r shall have the right to use its corporate and or trade_name s and its own trademark s and to determine the general design and appearance of such labeling packaging utilizing the labeling copy and or artwork provided by medchem p r alcon p r shall be responsible initially for producing finished labeling and or materials and attaching or accompanying such labeling to or with avitene medchem p r shall have the option of changing the labeling copy and or artwork for avitene packaging at any time upon days prior written notice to alcon p r medchem p r shall further have the option of assuming responsibility at any time for producing the finished labeling and packaging materials and delivering such materials to alcon p r for association with avitene provided that alcon p r has received days prior written notice of such a change delivery storage delivery alcon p r shall ship avitene ordered by medchem p r to such destination s as medchem p r shall designate in its order all deliveries of avitene under this agreement shall be f o b common carrier designated by medchem p r any potential liability for loss or damage that alcon p r may maintain by reason of its physical possession throughout the conversion process of the raw materials and finished avitene owned by medchem p r shall cease upon delivery of such avitene to a common carrier medchem p r shall be responsible for i the payment of all transportation charges taxes and other charges incident to the storage and movement of avitene in commerce subsequent to such transfer of the risk of loss to medchem p r and ii the cost of all insurance relating to the equipment raw materials inventory and the processing and storage of such avitene and such costs and charges shall not be included in the calculation of the processing costs storage related documentation at medchem p r ’s request and for so long as this -- - agreement is in effect alcon p r shall make available to medchem p r adequate warehouse space at the humacao plant for the storage of avitene processed pursuant to this agreement or purchased by medchem p r pursuant to the asset purchase agreement medchem p r shall have the right to inspect such warehouse space upon reasonable prior notice and during normal business hours acceptance and rejection of avitene by medchem p r in general except as set forth below medchem p r shall have the right within working days following actual receipt by medchem p r of any delivery to reject any avitene so delivered which does not conform in any material respect with the product specifications provided that such nonconformity did not result from contamination or other physical damage cause by medchem p r or third parties occurring after delivery other than contamination caused by subseguent delivery by alcon p r of contaminated avitene sic changes in conversion process alternative suppliers upon written consent by medchem p r alcon p r may alter the conversion process or obtain avitene from alternative suppliers for delivery to medchem p r testing by alcon p r alcon p r shall submit to medchem p r together with each shipment batch or lot of avitene delivered to medchem p r a written notice certifying that such shipment batch or lot of avitene meets in every material respect the product specifications and specifying the results of alcon p r ’s analysis of such shipment batch or lot testing by medchem p r medchem p r at its option may perform the acceptance tests on random sample packages of avitene in order to determine whether such avitene conforms in every material respect with the product specifications notice return retesting replacement medchem p r shall not be obligated to remit the processing fee to alcon p r for and shall notify -- - alcon p r in writing of the failure of any sample shipment or lot of avitene to meet in any material respect the product specifications medchem p r shall return to alcon p r any such rejected sample shipment or lot of avitene at alcon p r ’ss expense alcon p r at its expense shall replace any properly rejected sample shipment or lot of avitene alcon p r shall also reimburse medchem p r for any inventory loss due to warehouse damage damage resulting from the failure of the conversion process except for damage resulting from changes in the conversion process requested by medchem p r and instituted by alcon p r or the expiration of the expiration date of any avitene products stored by medchem p r in warehouse space provided by alcon p r provided that such expiration of the expiration date is as a result of actions or omissions by alcon p r with respect to the management of the inventory alcon p r will not be responsible for inventory losses due to product obsolescence product recalls if any avitene product is subjected to a recall by a governmental agency or in the event medchem p r after notification to and consultation with alcon p r elects to make such a recall based on medchem p r ’s good_faith belief that such avitene is defective or not in conformity with alcon p r ’s warranties alcon p r shall pay the actual out-of-pocket costs in connection with such recall including without limitation the replacement of recalled avitene the payment of such costs by alcon p r shall not be included in the computation of the processing fee pursuant to section hereof however if alcon p r was not in breach of its warranties medchem p r shall hold alcon p r harmless and shall bear all costs and expenses in connection with such recall payment processing cost in return for the processing services performed by alcon p r for medchem p r medchem p r shall pay to alcon p r a processing fee in connection with each order for avitene delivered pursuant to this agreement the processing fee shall be equal to alcon p r ’s processing cost as such term is defined below plus ten percent however the processing fee will be -- - adjusted at year end to account for manufacturing variances which shall be calculated pursuant to the terms of this section the processing fee shall be determined in two steps first on or before december of each year alcon p r shall determine the estimated processing cost for the coming year processing costs shall be composed of standard cost less the cost of raw materials owned by medchem p r and supplied to alcon p r for processing and the depreciation on machinery and equipment owned by medchem p r and used in the conversion process standard cost shall consist of the sum of estimated direct labor direct materials variable overhead fixed overhead and quality assurance cost and is defined in a referenced schedule standard cost shall not include costs associated with insurance provided by medchem p r freight or shipping costs which shall be separately billed to medchem p r by third parties standard cost also shall not include any direct_labor_costs incurred by medchem p r in connection with the provision of services by medchem p r employees at the humacao plant such estimated processing cost plus will then be used as the estimated processing fee throughout the year for purposes of billing medchem p r for the quantity of avitene produced each month second at the end of each year the parties shall determine any manufacturing and or processing variances by comparing the processing cost for such year with the actual cost and volumes of avitene during such year if the variances indicate that the cost to alcon p r to process the avitene was greater than the processing cost then medchem p r shall pay to alcon p r an amount of money equal to the total amount of such variance plus within days of medchem p r ’s receipt of written notice setting forth the amount of such variance if the variance indicates that the cost to alcon p r was less than the processing cost then medchem p r shall receive from alcon p r an amount of money equal to the total amount of such variance plus within days of the end of the year medchem p r shall have the right to engage an independent auditor upon reasonable written notice to examine the relevant books_and_records of alcon p r in order to confirm the accurate calculation of processing cost -- - option c processing fee in addition to the processing fee payable pursuant to sec_9_1 above medchem p r shall pay to alcon p r an option c processing fee in connection with the processing of corium to option c flour pursuant to this agreement the option c processing fee shall be determined in two steps first on or before december of each year alcon p r shall determine the option c processing cost of the option c flour the option c processing cost shall be composed of the option c standard cost less the cost of raw materials owned by medchem p r and supplied to alcon p r for processing and the depreciation on machinery and equipment owned by medchem p r and used in the conversion process option c standard cost shall consist of direct labor direct materials variable overhead fixed overhead and quality assurance cost and is defined in a referenced schedule option c standard cost shall not include costs associated with insurance provided by medchem p r freight or other costs which shall be separately billed to medchem p r by third parties option c standard cost also shall not include any direct_labor_costs incurred by medchem p r in connection with the provision of services by medchem p r employees at the humacao plant the option c processing cost plus will then be used throughout the year for the purposes of billing medchem p r for the quantity of option c flour produced each month the second step in determining the option c processing fee shall take place at the end of each year at that time alcon p r shall determine any manufacturing and or processing variances by comparing the option c processing cost for such year with the actual cost and volumes of option c flour during such year if the variances indicate that the cost to alcon p r to process the option c flour was greater than the option c processing cost then medchem p r shall pay to alcon p r an amount of money equal to the total amount of such variance plus within days of medchem p r ’s receipt of written notice setting forth the amount of such variance if the variance indicates that the cost to alcon p r was less than the option c processing cost then medchem p r shall receive from alcon p r an amount of money equal to the total amount of such variance plus within days of the end of the year medchem p r shall have -- - the right to engage an independent auditor upon reasonable written notice to examine the relevant books_and_records of alcon p r in order to confirm the accurate calculation of the option c processing cost payment medchem p r shall pay processing fees pursuant to alcon p r ’ss invoice for avitene delivered under any order within days following receipt by medchem p r of such invoice payment by medchem p r of any invoice submitted by alcon p r to medchem p r shall not be required with respect to any shipment or lot of avitene which has been properly rejected and returned by medchem p r in accordance with section payment of any disputed amount but only to the extent of the disputed amount shall be deferred until resolution of such dispute warranty general warranty inspection alcon p r warrants that any avitene delivered under this agreement shall meet the product specifications in every material respect and that at the time of delivery such avitene shall be uncontaminated and free from defects in materials and workmanship medchem p r may make changes in the product specifications but such changes must be made known to and agreed to by alcon p r which agreement shall not be unreasonably withheld or delayed and alcon p r shall promptly incorporate said change s in such products consistent with good manufacturing practices and regulatory requirements medchem p r shall have the right to inspect the humacao plant during mutually agreed upon times when the processing of avitene is in progress to insure that alcon p r ’s processing of avitene is in compliance with the product specifications this right of inspection granted to medchem p r shall not be deemed as granting to medchem p r access to any trade secrets retained by alcon p r subsequent to the closing of the transactions contemplated by the asset purchase agreements medchem p r indemnity medchem p r will indemnify and hold alcon p r harmless from any and all claims damages costs and or expenses including but not limited to attorneys fees arising directly from any change required by -- jo - medchem p r in the product specifications or the conversion process from the manner in which such procedures were carried out by alcon p r as of the date of this agreement if such change is the proximate cause of such claim damages costs or expenses the promotion distribution sale and or internal use by medchem p r of avitene processed by alcon p r hereunder unless at the time of delivery such avitene did not meet the warranty set forth in sec_11 hereof and any breach by medchem p r of its warranties and obligations under this agreement upon the filing of any such claim or suit alcon p r shall immediately notify medchem p r thereof and shall permit medchem p r at its cost to handle and control such claim or suit provided however that alcon p r may at itss own expense retain such additional attorneys as it may deem necessary which attorneys will be permitted to reasonably observe and or participate in all aspects of but not control the defense of such claims or suits medchem p r shall have the right after consultation with alcon p r to resolve and settle any such claims or suits this indemnity shall not abrogate or in any way modify the obligations of alcon p r pursuant to the representations and warranties contained in the asset purchase agreement alcon p r indemnity alcon p r will indemnify and hold medchem p r harmless from and against any and all liability damage loss cost or expense resulting from any third party claims made or suits brought against medchem p r which arise from alcon p r ’s breach of any provision of this agreement including but not limited to claims of product defect relating to avitene which is not in conformity with the warranty set forth in sec_11 hereof upon the filing of any such claim or suit medchem p r shall immediately notify alcon p r thereof and shall permit alcon p r at its cost to handle and control such claim or suit provided however that medchem p r may at its own expense retain such additional attorneys as it may deem necessary which attorneys will be permitted to reasonably observe and or participate in all aspects of but not control the defense of such claims or suits alcon p r shall have the right after consultation with medchem p r to resolve and settle any such claims or suits - 7jl1- term and termination term of agreement the term of this agreement shall commence on the date hereof and shall end on date unless sooner terminated pursuant to this sec_12 and may be renewed on terms and conditions mutually satisfactory to the parties hereto insolvency default a in general except as otherwise provided in this sec_12 either party at its option may terminate this agreement upon the occurrence of any breach by the other party provided however that the nonbreaching party shall have delivered to the breaching party a written notice specifying such breach in reasonable detail ii that the breaching party shall not have cured such breach within days after receipt of the notice and that the nonbreaching party must exercise its option to terminate this agreement within days after the expiration of the cure period bob failure to deliver by alcon p r subject_to the provisions of sec_12_3 of this agreement medchem p r may terminate this agreement if alcon p r fails to deliver avitene ordered by medchem p r under this agreement provided however that medchem p r shall have delivered to alcon p r a written notice of such failure to deliver that alcon p r shall have failed to make delivery within days after receipt of such written notice and iii that medchem p r must exercise its option to terminate this agreement within days after the expiration of the cure period alcon p r acknowledges and agrees that if alcon p r fails to deliver avitene ordered by medchem p r under this agreement medchem p r may make alternative arrangements at alcon p r ’s expense for the processing of avitene for the then remaining term of this agreement however alcon p r shall not be liable for any incidental or consequential damages sustained by medchem p r due to such failure to deliver - j2 - c force majeure establishment of medchem p r plant medchem p r may terminate this agreement pursuant to the provisions of section remedies not exclusive in the event of a breach of this agreement the rights of termination provided in this sec_12 shall not be exclusive of any remedies to which either party may be entitled at law or in equity as limited by the express terms of this agreement provided however that such other remedies shall not be subject_to the time limitations set forth in sec_12_3 and b medchem p r plant the parties acknowledge and agree that during the term of this agreement medchem p r will take steps designed to establish alternative facilities the medchem p r plant that will enable medchem p r to undertake the conversion process in connection with the establishment of the medchem p r plant medchem p r shall bear the costs of removing the equipment from the humacao plant including but not limited to the costs of repairing any damage to the humacao plant caused by such removal alcon p r covenants that it will provide reasonable assistance to medchem p r in establishing the medchem p r plant including training of the humacao plant manager and other appropriate medchem p r personnel in all aspects of the conversion process in this regard appropriate medchem p r employees shall have the right during the term of this agreement to observe with regard to the conversion process carried out by alcon p r at the humacao plant however such medchem p r employees will not participate in alcon p r ’s management process in addition upon the construction of the medchem p r plant alcon p r will assist with the validation of three initial avitene production batches of each avitene product produced at the medchem p r plant when medchem p r has successfully established the necessary machinery equipment and guality control procedures implemented the conversion process at the medchem p r plant and in the sole opinion of medchem p r conducted satisfactory validation tests and received all applicable -- - governmental approvals relating to the operation of the medchem p r plant medchem p r shall have the right to terminate this agreement prior to date upon at least ninety days prior written notice to alcon p r applicable law the validity performance and construction of this agreement shall be governed by the laws of the commonwealth of massachusetts notices notices and other communications by a party under this agreement shall be in writing and hand-delivered deposited with an overnight carrier for next day delivery or deposited in the united_states mail as certified mail return receipt requested postage prepaid addressed to the parties as follows or to such other addresses as either party may designate from time to time in writing if to alcon p r alcon laboratories inc south freeway forth worth tx attention henry meadows vice president and controller surgical specialty division if to medchem p r medchem puerto rico inc nagog park acton ma attention president and shall be deemed given when received no agency relationship neither party shall be deemed to be the agent of the other party for any purpose alcon p r shall be deemed an independent_contractor for the purposes of its performance of services for medchem p r -- the parties hereto have executed this agreement as a sealed instrument and this agreement becomes duly effective as of the date first written above medchem puerto rico inc by s david a swann title ceo alcon puerto rico inc by s title vice president