Court Opinion

ID: 4333275
Source: CourtListenerOpinion
Date Created: 2018-11-14 01:07:24.007079+00
Date Added: 2024-06-11T14:47:06.060402
License: Public Domain

116 T.C. No. 25

                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. 4065-98, 4066-98.             Filed May 18, 2001.

     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 Dec. 18, 1987, 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 10 percent. Throughout
most of the relevant period, P-PR had no employees and
                               - 2 -

     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 1992 Federal income tax return that it
     was entitled to a $1,993,264 Puerto Rico and possession
     tax credit under sec. 936(a), 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(a)(2)(B), I.R.C., by virtue of: (1) A’s activities
     in Puerto Rico, (2) the fact that A manufactured
     Avitene using P-PR’s raw materials and equipment, (3)
     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
     (4) 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(a)(2)(B), I.R.C.; i.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 122.    Respondent determined an

$815,196 deficiency in the Federal income tax of MedChem (P.R.),

Inc. (MedChem P.R.), for its taxable year ended August 31, 1992.

Respondent determined a $1,705,019 deficiency in the Federal

income tax of MedChem Products, Inc., & Subsidiaries (MedChem
                                - 3 -

Group) for its taxable year ended August 31, 1992.    Following

concessions, we must decide whether MedChem P.R. meets the

“active conduct of a trade or business within a possession”

requirement of section 936(a)(2)(B).    We hold it does not.1

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:    (1) The 20½-month period from

December 18, 1987, to August 31, 1989, that preceded the 3-year

test period relating to our determination under section

936(a)(2)(B), (2) the 3-year test period from September 1, 1989,

to August 31, 1992, and (3) the 20-month period from August 31,

1992, to April 1994 that followed the 3-year test period.2

                           Background

     The parties have filed with the Court a stipulation of facts

and certain related exhibits.   We incorporate herein by reference

     1
       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)(1)(A).
     2
       We take into account petitioners’ actions in years
subsequent to their 1992 taxable year to evaluate their prospects
during their 1992 year. See Levin v. Commissioner, 832 F.2d 403,
406 n.3 (7th Cir. 1987) (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 T.C. 698 (1986).
                               - 4 -

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

December 8, 1987, as MedChem Puerto Rico, Inc., it changed its

name on December 22, 1987, to BioChem Products, Inc., it changed

its State of incorporation on March 1, 1992, to Massachusetts,

and it changed its name on November 25, 1992, 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 31.

During each of MedChem P.R.’s taxable years ended on August 31,

1990, 1991, and 1992, all of its reported income was “intangible

property income”, sec. 936(h)(3), 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
                               - 5 -

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 1 gram finished flour.

     MedChem U.S.A. leases office, research, and manufacturing

facilities in Woburn.   It leased 32,000 square feet in 1989, and

its 63 full-time employees on August 31, 1991, worked in that

space.   On August 31, 1992, MedChem U.S.A. leased approximately

50,000 square feet at two facilities in Woburn.   MedChem U.S.A.’s

144 full-time employees on August 31, 1992, 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 June 30, 1990.   MedChem

P.R.’s only employee before July 1, 1990, was Jose Perez, and

MedChem P.R. terminated him on June 30, 1990.   Nor did any of

MedChem P.R.’s officers or directors have an office in Puerto

Rico after June 30, 1990.   All of MedChem P.R.’s officers and

directors, except Mr. Perez, were officers and/or directors of
                                              - 6 -

MedChem U.S.A., and, after June 30, 1990, none of MedChem P.R.’s

officers or directors was paid by MedChem P.R.

      The individuals connected with the Avitene business are

listed below by name, affiliate, office location, position, and

period of affiliation in the listed capacity.
                                            Office                                    Period of
       Name               Affiliate         Location          Position                Affiliation
                                                                                           1
  Acosta, Eugenia       MedChem U.S.A.       Woburn    Manager quality systems
  Alifonso, Ramon       Alcon P.R.           P.R.      Director of manufacturing       1985-93
  Brophy, Frank         MedChem U.S.A.       Woburn    Vice president-mkt.& sales   2/28/90-9/26/91
                                                       Vice president–marketing     9/26/91-8/31/92
  Carrion, Jimmy        Alcon P.R.           P.R.      Avitene production manager      1992-95
  Castro, Raymond       Kelly, Alcon P.R.    P.R.      Planner/buyer                   1990-91
  Donaldson, Jonathan   MedChem U.S.A.       Woburn    Director                      9/1/89-8/31/92
                                                       President/chief oper. off.    9/1/89-8/31/92
                                                       Clerk                         9/1/89-8/31/92
                        MedChem P.R.         Woburn    President                     9/1/89-8/31/92
                                                       Secretary                     9/1/89-4/12/91
                                                       Director                      9/8/89-8/31/92
  Falvey, Paul          MedChem U.S.A.       Woburn    Assistant treasurer          12/1/89-8/31/92
  Ferdman, Ariel        MedChem U.S.A.       Woburn    Dir. of core technology         1988-94
  Geffken, Daniel       MedChem U.S.A.       Woburn    Treasurer                    12/1/89-5/29/91
                                                       Chief financial officer      2/28/90-5/29/91
                        MedChem P.R.         Woburn    Treasurer                     9/1/89-5/29/91
                                                       Assistant secretary           9/1/89-4/12/91
                                                       Secretary                    4/12/91-2/17/92
  Hansen, Lee           Alcon P.R.           P.R.      General plant manager           1981-94
                                                                                           1
  Micale, Domenic       MedChem U.S.A.       Woburn    Production supervisor
  Moran, Sean           MedChem U.S.A.       Woburn    Treasurer                    5/29/91-8/31/92
                        MedChem P.R.         Woburn    Secretary/clerk              2/27/92-8/31/92
                                                       Treasurer                    2/27/92-8/31/92
                                                                                           1
  McDonough, John       MedChem U.S.A.       Woburn    Financial employee
  Perez, Jose           MedChem P.R.         P.R.      General manager              2/29/88-6/29/90
                                                       Assistant treasurer           9/1/89-6/29/90
  Rivera, Luis          Kelly                P.R.      Planner/buyer                      1992
  Rodriguez, Maria      Alcon P.R.           P.R.      Avitene prod. supervisor        1990-92
                                                                                           1
  Rudolph, Cathy        MedChem U.S.A.       Woburn    Quality assurance worker
  Santiago, Maria       Alcon P.R.           P.R.      Director quality assur.         1980-94
                                                                                           1
  Severance, Scott      MedChem U.S.A.       Woburn    Vice president, operations
  Shepherd, Ronald      MedChem U.S.A.       Woburn    Dir. materials manager          1990-94
  Singer, Steven        MedChem U.S.A.       Woburn    Assistant clerk               9/1/89-8/31/92
                        MedChem P.R.         Woburn    Assistant secretary/clerk     9/1/89-8/31/92
                                                                                           1
  Stevens, James        MedChem U.S.A.       Woburn    Dir. qlty. control/assur.
  Sullivan, Bernard     MedChem U.S.A.       Woburn    Vice president–operations     9/1/89-9/26/91
                                                       Sr. vice president-operat.   9/26/91-8/31/92
                        MedChem P.R.         Woburn    Director                      9/1/89-2/28/92
  Swann, David          MedChem U.S.A.       Woburn    Director/chairman             9/1/89-8/31/92
                                                       Chief executive officer       9/1/89-8/31/92
                        MedChem P.R.         Woburn    Director/chairman             9/1/89-8/31/92
                                                                                           1
  Tanny, Jay            MedChem U.S.A.       Woburn    Cost accountant
  Velez, Nelson         Alcon P.R.           P.R.      Planner/buyer                   1991-92

      1
       The individual’s affiliation occurred sometime between December 1987 and September 1992.

      MedChem U.S.A. initially sold only one product, Amvisc.

Amvisc, which is unrelated to Avitene, is a hyaluronic-acid-based
                                - 7 -

product used to lubricate and separate tissues in ophthalmic

surgical procedures.   MedChem U.S.A. decided in 1987 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 1984 and were seeking

an injunction and treble damages.

     On December 18, 1987, 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 $31 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 $1,085,000, a non-competition
                                - 8 -

agreement valued at $200,000, goodwill valued at $4,490,000,

contract rights valued at $5,000, and records valued at $5,000;

Alcon Labs sold to MedChem P.R. receivables valued at $1.3

million and inventory valued at $2.5 million.    Under the second

agreement, Alcon P.R. sold to MedChem U.S.A. patents and related

know-how valued at $2.6 million, trademarks valued at $1.9

million, various Food and Drug Administration (FDA) approvals

(including the pre-market approval for Avitene) valued at

$300,000, a non-competition agreement valued at $200,000,

goodwill valued at $4,910,000, and contract rights valued at

$5,000.    Under the third agreement, Alcon P.R. sold to MedChem

P.R. inventory valued at $10.1 million and machinery and

equipment valued at $800,000; 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.

     Each of the asset purchase agreements required that the

Alcon Entities manufacture and sell to petitioners 20,000 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 December 31,

1990.   At all times during the 3-year period ended August 31,
                                - 9 -

1992, 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.3   MedChem P.R. would invoice MedChem

U.S.A. (or the other purchaser) for the Avitene sold to it at a

price equal to MedChem P.R.’s manufacturing cost plus 10 percent.

From September 1, 1989, through August 31, 1992, 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 August 31, 1992,

     3
       The sole exception concerned the sale of Avitene for
distribution in Japan through June 6, 1991. In that case,
MedChem P.R. sold Avitene to Alcon Pharmaceuticals, which owned
the distribution rights to the Japanese market until June 6,
1991; 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 June 6, 1991, for $15
million, and MedChem U.S.A. transferred those rights to MedChem
P.R. on August 31, 1992. MedChem P.R.’s sales of Avitene for the
Japanese market accounted for approximately 20 percent of its
total net sales of Avitene.
                               - 10 -

designated Alcon P.R. as Avitene’s manufacturer.    The labels

read:

     Manufactured by:      Alcon P.R.
                           Humacao, Puerto Rico 00661

     For:                  MedChem P.R.
                           Humacao, Puerto Rico 00661

     Distributed by:       MedChem U.S.A.
                           Woburn, Massachusetts 01801

     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.4

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:    (1) MedChem U.S.A. and Alcon Labs, (2) MedChem U.S.A. and

Alcon Pharmaceuticals, and (3) 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

     4
       Neither petitioner has ever had an Avitene manufacturing
facility in Puerto Rico.
                               - 11 -

substantially the same form, function, or application as Avitene

during the 5-year period commencing on December 19, 1987.

     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 August 31, 1992, 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 December 31, 1990, but

was extended on four separate occasions to June 30, 1991,

December 31, 1992, December 31, 1994, and the earlier of March 1,

1995, or the date on which Alcon P.R. completed a set delivery

schedule, respectively.   From September 1, 1989, through August

31, 1992, 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
                             - 12 -

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

          (1) 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.

          (2) The corium was machine cut into approximately
     4 square inch pieces, manually inspected for
     imperfections, and machine cut into smaller pieces of
     approximately one square inch in size.

          (3) The smaller pieces were acidified, washed with
     alcohol, and tested against product specifications.

          (4) 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 in a
     rotary dryer.

          (5) 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.
                             - 13 -

                            Phase II

          (6) 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.

          (7) 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.

          (8) As to the manufacturing of finished flour,
     jars were machine washed, loaded into trays and carts,
     and dried in a walk-in oven.

          (9) 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.

          (10) The dried jars (with bulk flour inside) were
     transferred by carts to the capping room where they
     were capped.

          (11) 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.

          (12) 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 December 18, 1987, agreements were entered into,

petitioners intended to have that facility ready to take over the
                              - 14 -

manufacturing of Avitene at the end of the processing agreement’s

original 3-year term.

     In February 1988, Jonathan Donaldson traveled to Humacao and

interviewed Mr. Perez for a position with MedChem P.R.5    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 June 30,

1990, reporting directly to Bernard Sullivan or to Mr. Sullivan’s

superior, Mr. Donaldson.   Mr. Perez worked from May 1988 through

June 30, 1990, 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

     5
       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.
                               - 15 -

manufacturing of Avitene.    From March 1988 through approximately

June 1988, Mr. Perez spent approximately 75 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 70 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 1989, and Wanda

Rodriguez worked in the office from October 1989 to June 1990.

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.
                              - 16 -

     On June 21, 1989, MedChem P.R. paid $842,500 to the Puerto

Rico Industrial Development Co. for approximately 8.5 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 6 months, that

construction of the building would begin within 6 months of the

plans’ approval, that the completed building would be devoted to

manufacturing operations for a minimum period of 10 years, that

the building would include 30,000 square feet of ground floor

space and 13,000 square feet of mezzanine space, and that MedChem

P.R. would use its reasonable efforts to employ 50 people at the

commencement of the facility’s manufacturing operations and 120

people within 18 months thereafter.    Petitioners anticipated that

the proposed facility would cost at least $9 million to build,

and, through January 31, 1990, MedChem P.R. made $885,216.56 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 1990, MedChem U.S.A. suffered a devastating

financial blow from the Amvisc litigation.   On February 2, 1990,

the District Court hearing the case issued a preliminary
                              - 17 -

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 $10 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

1990, 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 February 1990, MedChem P.R. wrote off for

financial accounting and tax purposes all of the capitalized

expenditures ($881,966) 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,
                              - 18 -

petitioners decided to move during the fall of 1990 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.6   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 July 1, 1990, 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 June 1990.7

Within 7 months, they moved into that facility all or part of the

frozen corium and the equipment used to process bulk flour into

     6
       MedChem U.S.A. eventually constructed a bulk Avitene
manufacturing facility in Woburn in June 1992 and began producing
bulk Avitene there 4 months later. In July 1993, 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
April 1994, at which time MedChem U.S.A. controlled Avitene’s
entire manufacturing process.
     7
       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.
                              - 19 -

nonwoven web.8   These two groups of equipment constituted all of

the manufacturing equipment necessary to perform the work in

phase 1 of the manufacturing process; as of the later date, all

of the manufacturing equipment related to phase 1 was located in

MedChem U.S.A.’s facility in Woburn.   By January 1, 1991,

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 2 of the

manufacturing process, i.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 1995

at which time it was shipped to the Woburn facility.    Alcon P.R.

continued in Puerto Rico until early 1995 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 1989 and 1990; 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 1990, Alcon P.R. planned to use the part of

     8
       On separate occasions, MedChem U.S.A. reported to the
Securities and Exchange Commission (SEC) that, as of Nov. 30,
1990, and as of Feb. 28, 1991, respectively, MedChem U.S.A. was
in the process of redesigning its Amvisc manufacturing facility
in Woburn in order to start manufacturing Avitene there.
                              - 20 -

the plant where the equipment had been located for non-Avitene

products.

     Alcon P.R. devoted 30 to 35 of its full-time production line

employees to the manufacturing of Avitene before June 1990, and

it devoted 12 to 15 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 30 to 35

production line employees who worked on Avitene before June 1990,

approximately 15 to 20 worked in phase 1 of the manufacturing

process, and the remainder worked in phase 2.    The number of

Alcon P.R. employees producing Avitene decreased in June 1990

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

January 1990 to January 1, 1992, 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 85 to 100.   The director, Maria

Santiago, reported to Alcon Labs’ quality assurance director in
                              - 21 -

Fort Worth, Texas.   Alcon P.R. was responsible for the quality 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

quality 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 quality 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 in a

warehouse or quarantine cage awaiting distribution to its

customers (i.e., the end users).    MedChem U.S.A. performed

secondary quality tests on the finished Avitene product at its

quality assurance department in Woburn.    MedChem P.R. did not

have a quality assurance department, and it never tested Avitene

for quality 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 August 26,

1991, to October 27, 1993, identified Alcon P.R. as Avitene’s
                                - 22 -

manufacturer.     MedChem U.S.A. also reported to the SEC for most

of 1989 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 August 1992.    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

November 1992.    Ariel Ferdman generally directed MedChem U.S.A.’s

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 1990 through 1992, 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
                              - 23 -

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 August 1990 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 June 1990 through August 31, 1992, 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. $20.40 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 July 1990 through August
                               - 24 -

31, 1992, as the Avitene planner/buyer.9    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:   (1) Attended

weekly manufacturing meetings held with Alcon P.R. managers at

Alcon P.R.’s facility, (2) monitored the inventories of materials

used in the manufacturing process, (3) 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), (4) 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 (5) 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 June 30, 1990, through March 1991.

Kelly hired him and paid him $12.02 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.

     9
         Before this time, Mr. Perez was the planner/buyer.
                              - 25 -

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 March 1991,

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

March 1991 through April 1992.   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 50 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 April 1992 to August 31, 1992.    Kelly hired

him and paid him $12 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
                               - 26 -

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 November 1,

1993, when he was retained by MedChem P.R. as an independent

consultant.

     Mr. Sullivan supervised MedChem U.S.A.’s Amvisc operation

through 1993.    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:   (1) He

prepared and maintained schedules listing MedChem U.S.A.’s

requirements for Avitene for specified periods during the year,

(2) he forwarded those schedules to Mr. Shepherd to deliver (or

sometimes he delivered them himself) to Alcon P.R. and to the

planner/buyer, (3) he reviewed the results of the quality

assurance tests which were prepared by and received from Alcon

P.R., and (4) 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 September 25, 1991.   MedChem P.R. used that account to
                              - 27 -

pay the routine operating expenses (e.g., office rent, supplies)

of its Humacao office.   On September 5, 1991, 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 September 4, 1991, 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 30 percent of

his time on Avitene financial matters.10

     For its fiscal year ended on August 31, 1992, MedChem P.R.

elected under section 936(h)(5) 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 50 percent of the total Avitene product line cost

of sales and selling, general, and administrative expenses.

     10
       Daniel Geffken also reported to Mr. Donaldson. Mr.
Geffken spent less than 50 percent of his time on Avitene-related
matters.
                                - 28 -

Those statements indicate that cost of goods sold of $1,730,804

and selling, general, and administrative expenses (including the

salary expense of MedChem U.S.A. employees working on Avitene

matters) of $2,789,224 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:    (1) Taxable income of $5,862,541 and (2)

direct labor costs of $323,000.    MedChem P.R. claimed a

$1,993,264 tax credit under section 936(a).

                              Discussion

     The parties dispute whether MedChem P.R. may calculate its

1992 Federal income tax liability by using the Puerto Rico and

possession tax credit (possession tax credit) provided under

section 936(a).    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.--

               (1) In general.--Except as otherwise
          provided in this section, if a domestic
          corporation elects the application of this
          section and if the conditions of both
          subparagraph (A) and subparagraph (B) of
          paragraph (2) are satisfied, there shall be
          allowed as a credit against the tax imposed
          by this chapter an amount equal to the
          portion of the tax which is attributable to
          the sum of--

                        (A) the taxable income, from
                  sources without the United States,
                  from–
                             - 29 -

                         (i) the active
                    conduct of a trade or
                    business within a
                    possession of the United
                    States, or

                         (ii) the sale or
                    exchange of substantially
                    all of the assets used by
                    the taxpayer in the
                    active conduct of such
                    trade or business, and

                    (B) the qualified possession
               source investment income.

               (2) Conditions which must be satisfied.-
          -The conditions referred to in paragraph (1)
          are:

                    (A) 3-year period.--If 80
               percent or more of the gross income
               of such domestic corporation for
               the 3-year period immediately
               preceding the close of the taxable
               year (or for such part of such
               period immediately preceding the
               close of such taxable year as may
               be applicable) was derived from
               sources within a possession of the
               United States (determined without
               regard to section 904(f)); and

                    (B) Trade or business.--If 75
               percent or more of the gross income
               of such domestic corporation for
               such period or such part thereof
               was derived from the active conduct
               of a trade or business within a
               possession of the United States.

     Respondent determined and contends that none of MedChem

P.R.’s taxable income for its fiscal year ended August 31, 1992,
                              - 30 -

qualifies for the possession tax credit.11    Respondent argues

primarily that MedChem P.R. did not meet the active conduct of a

trade or business requirement of section 936(a)(2)(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

     11
       As an alternative to this determination, respondent
determined that MedChem P.R.’s income was taxable to the MedChem
Group under sec. 482(a). Because respondent does not pursue this
argument on brief, we consider it conceded.
                              - 31 -

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 section

936(a)(2)(B).   As we read section 936(a), 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:    (1)

Its active conduct of a trade or business in a U.S. possession or

(2) 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 section 936(a)(2)(A) and

the 75-percent test of section 936(a)(2)(B).   We concern

ourselves only with the 75-percent test of section 936(a)(2)(B)

because the parties agree that MedChem P.R. has met the 80-

percent test.   Under the 75-percent test, MedChem P.R. qualified

for the possession tax credit if at least 75 percent of its gross

income for the 3-year period ended August 31, 1992, was derived
                                - 32 -

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.

Higgins v. Commissioner, 312 U.S. 212, 217 (1941); Deputy v. du

Pont, 308 U.S. 488, 496 (1940); Welch v. Helvering, 290 U.S. 111,

115 (1933); Plymouth Sav. Bank v. United States, 187 F.3d 203,

210 (1st Cir. 1999).     Because Congress has not explicitly defined

the phrase “active conduct of a trade or business” for purposes

of section 936(a) (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 section

162(a):

             The phrase “trade or business” has been in §
        162(a) and in that section’s predecessors for many
        years. Indeed, the phrase is common in the Code, for
        it appears in over 50 sections and 800 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 60 times in
        the Code. The concept thus has a well-known and almost
        constant presence on our tax-law terrain. Despite
                             - 33 -

     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. [Commissioner v. Groetzinger, 480
U.S. 23, 26 (1987); 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

section 936(a), 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 section 936 as reflected in its legislative history.12

Cf. Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 216

(1998) (Court interpreted the subject phrase for purposes of

section 355 by reference to the definition set forth in the

regulations prescribed under section 355).   Our research reveals

that the phrase “active conduct of a trade or business” appears

22 times in the current version of the Internal Revenue Code13

and that the Secretary has issued extensive regulations

interpreting that phrase in three of those sections.   First, for

     12
       Of course, we also bear in mind the Supreme Court’s
interpretation of the phrase “trade or business” as espoused in
Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); to wit, an
activity in which a taxpayer is involved with continuity,
regularity, and a profit-motivated primary purpose.
     13
       See secs. 30A, 49, 168, 179, 351, 355, 367, 407, 543,
731, 806, 861, 865, 936, 954, 957, 995, 1202, 1298, 1362, 2057,
4001.
                                - 34 -

purposes of section 179, the Secretary prescribed in section

1.179-2(c)(6), Income Tax Regs., the following relevant rules as

to the meaning of the phrase:

               (6) Active conduct by the taxpayer of a trade
     or business--(i) Trade or business. For purposes of
     this section and § 1.179-4(a), the term “trade or
     business” has the same meaning as in section 162 and
     the regulations thereunder. * * *

                    (ii) 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 section 179(b)(3)(A). In the context of
     section 179, the purpose of the active conduct
     requirement is to prevent a passive investor in a trade
     or business from deducting section 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 section 355, the Secretary

prescribed in section 1.355-3(b)(2), Income Tax Regs., the

following relevant rules as to the phrase’s meaning:

               (2) Active conduct of a trade or business
     immediately after distribution--(i) In general. For
     purposes of section 355(b), 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
     (b)(2)(ii), (iii), and (iv) of this section.

                    (ii) 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
                             - 35 -

     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.

                    (iii) Active conduct. For purposes of
     section 355(b), 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 (iii) 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 section 367, the Secretary prescribed

in section 1.367(a)-2T(b), Temporary Income Tax Regs., 51 Fed.

Reg. 17942 (May 16, 1986), the following relevant rules as to the

phrase’s meaning:

          (b) Active conduct of a trade or business outside
     the United States--(1) 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
                        - 36 -

property is subject to the exception provided by this
section, four factual determinations must be made:

               (i) What is the trade or business of the
transferee;

               (ii) Do the activities of the transferee
constitute the active conduct of that trade or
business;

               (iii) 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)(2), (3), (4), and (5) of this section.

          (2) 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)(3) 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. * * *

          *    *    *    *    *    *    *
                        - 37 -

          (3) 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)(3) is illustrated by the
following example.

          Example. X, 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. Z contracts all of its operational and research
activities to Y for an arm’s-length fee. Z’s
activities do not constitute the active conduct of a
trade or business.

          (4) 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
                              - 38 -

     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.

               (5) 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--

                    (i) Held for the principal purpose of
     promoting the present conduct of the trade or business;

                    (ii) Acquired and held in the ordinary
     course of the trade or business; or

                    (iii) Otherwise held in a direct
     relationship to the trade or business. * * *

     As to Congress’ intent for section 936, the roots of that

section are found in section 262 of the Revenue Act of 1921, ch.

136, 42 Stat. 271, which exempted a U.S. corporation from Federal

taxes on foreign-source income if it derived at least 80 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 section 931 of the Internal Revenue Code of 1954.   Congress

promulgated section 931 and its predecessors to encourage

American businesses to invest in U.S. possessions.   See G.D.
                              - 39 -

Searle & Co. v. Commissioner, 88 T.C. 252, 350-351 (1987); see

also Coca-Cola Co. & Subs. v. Commissioner, 106 T.C. 1, 21

(1996).   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 1913, ch. 16, sec. II, 38 Stat. 166; Revenue

Act of 1918, ch. 18, 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 section 931 to remove that competitive

disadvantage.   See H. Rept. 350, 67th Cong., 1st Sess. 1 (1921),

1939-1 C.B. (Part 2) 168, 174.   In its original form, section 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 section

246(a)(2)(B), possessions corporations amassed large amounts of

income not repatriated to the United States.

     In the Tax Reform Act of 1976, Pub. L. 94-455, sec. 1051, 90

Stat. 1643, Congress revised the prior law in order to provide
                               - 40 -

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 at 22.

In place of the exemption mechanism contained in section 931,

Congress enacted section 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 section 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 10 to 15 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
                        - 41 -

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 is 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
                             - 42 -

     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 liquidation 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 48 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.
     94-938, at 277-278 (1976), 1976-3 C.B. (Vol. 3) 57,
     315-316; fn. refs. omitted.]

See also H. Rept. 94-658, at 254-255 (1975), 1976-3 C.B. (Vol. 2)

945, 946-947.
                              - 43 -

     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 section 936(a) 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 in a U.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 section

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 section

162(a), we believe that, for purposes of section 936(a), a

taxpayer actively conducts a trade or business in a U.S.

possession only if it participates regularly, continually,

extensively, and actively in the management and operation of its

profit-motivated activity in that possession.   Cf. Commissioner

v. Groetzinger, 480 U.S. at 26; Higgins v. Commissioner, 312 U.S.

at 217; Stanton v. Commissioner, 399 F.2d 326, 329-330 (5th Cir.

1968), affg. T.C. Memo. 1967-137.   We also believe that, for the

purpose of this participation requirement, the services
                              - 44 -

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 June 30, 1990.   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
                              - 45 -

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 section 936(a).     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,
                              - 46 -

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 June

30, 1990, 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 1990.    In 1990,

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

1 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.14

     14
       We distinguish Frank v. International Canadian Corp., 308
F.2d 520 (9th Cir. 1962), 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...)
                                - 47 -

For purposes of section 936(a), 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. 94-938, supra at 277-278,

1976-3 C.B. (Vol. 3) at 315-316; see also H. Rept. 94-658, supra,

1976-3 C.B. (Vol. 2) at 946-947.    All of MedChem P.R.’s business

activities after June 30, 1990, 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 (e.g., 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.15    Avitene was manufactured in Puerto Rico

     14
      (...continued)
in Frank concerned whether the taxpayer actively conducted a
trade or business and did not concern where that trade or
business was located.
     15
          Petitioners rely in part on their assertion in brief that
                                                      (continued...)
                               - 48 -

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.16   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;

       15
      (...continued)
the parties have stipulated that “100 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 “100 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.
       16
       Although MedChem U.S.A. occasionally performed limited
quality assurance tests on finished Avitene, MedChem P.R.
performed no quality testing at all.
                              - 49 -

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 23 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
                               - 50 -

the 3-year period.17   While it is true that petitioners continued

to use the trade or business of Alcon P.R. to manufacture Avitene

after June 30, 1990, while MedChem U.S.A. established an Avitene

manufacturing facility in Woburn, the use of Alcon P.R.’s

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 3-

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

     17
       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.
                               - 51 -

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:

(1) Mr. Perez and his staff from September 1, 1989, through June

30, 1990, (2) Messrs. Castro and Rivera from July 1990 through

March 1991 and from April through August 1992, (3) Messrs. Castro

and Velez from April 1991 through April 1992, (4) MedChem P.R.

officers and/or directors Donaldson, Geffken, Moran, Sullivan,

and Swann, (5) MedChem U.S.A. employees Acosta, Falvey, Ferdman,

Micale, McDonough, Rudolph, Severance, Shepherd, Stevens, and

Tanny, and (6) 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, e.g., Nationwide Mut. Ins. Co. v.

Darden, 503 U.S. 318, 322-324 (1992); Matthews v. Commissioner,

92 T.C. 351, 360 (1989), affd. 907 F.2d 1173 (D.C. Cir. 1990);

Professional & Executive Leasing, Inc. v. Commissioner, 89 T.C.
225, 232 (1987), affd. 862 F.2d 751 (9th Cir. 1988); Simpson v.

Commissioner, 64 T.C. 974, 984-985 (1975); see also sec.

3121(d)(2).    Factors commonly considered by courts in determining

such a relationship are the:    (1) Right to control the details of
                              - 52 -

the work, (2) furnishing of the tools and the work place, (3)

withholding of taxes, workers’ compensation, and unemployment

insurance funds, (4) right to discharge, and (5) permanency of

the relationship.   See Professional & Executive Leasing, Inc. v.

Commissioner, 862 F.2d at 753 (citing United States v. Silk, 331
U.S. 704, 714-716 (1947); Simpson v. Commissioner, supra at

984-985).   Although each factor is important, the test that is

usually considered fundamental is set out in the regulations.

Section 31.3401(c)-1(b), 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 is 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. * * * 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 secs. 31.3121(d)-1(c)(1) and 31.3306(i)-1(b), Employment

Tax Regs., providing language virtually identical to sec.

31.3401(c)-1(b), Employment Tax Regs., in the case of the Federal

Insurance Contributions Act and the Federal Unemployment Tax Act,

respectively.
                              - 53 -

     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 July 1, 1990.   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.
                              - 54 -

     We conclude and hold that MedChem P.R. does not meet the

“active conduct of a trade or business within a possession”

requirement of section 936(a)(2)(B).   In so holding, we note that

petitioners rely erroneously on Suzy’s Zoo v. Commissioner, 114
T.C. 1 (2000), 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 section 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
                               - 55 -

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 155.
                             - 56 -

                           APPENDIX A

Pre-Sec. 936(a)(2)(B) Test Period (1987 to Aug. 31, 1989)

Dec. 18, 1987       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 Dec.
                    31, 1990.

Feb. 29, 1988       MedChem P.R. hires Mr. Perez and establishes
                    a one-room office in Humacao.

June 21, 1989       MedChem P.R. purchases land for the
                    construction of an Avitene manufacturing
                    facility in Puerto Rico.

Sec. 936(a)(2)(B) Test Period (Sept. 1, 1989, to Aug. 31, 1992)

Feb. 2, 1990        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.

Feb. 28, 1990       MedChem U.S.A. initiates plans to locate an
                    Avitene manufacturing facility into its idled
                    Amvisc facility in Woburn during the fall of
                    1990.

June 30, 1990       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.

July 1, 1990        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.
                             - 57 -

December 1990       Petitioners move their bulk nonwoven web
                    manufacturing equipment from Humacao to
                    Woburn.

March 1991          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.

April 1992          Kelly hires Mr. Rivera to replace Mr. Velez
                    as Avitene planner/buyer.

August 1992         FDA audits the Avitene manufacturing process
                    and deals almost exclusively with Alcon P.R.
                    personnel.

Post-Sec. 936(a)(2)(B) Period (Aug. 31, 1992, to Apr. 1994)

October 1992        MedChem U.S.A. starts manufacturing Avitene
                    in Woburn.

July 1993           MedChem U.S.A. begins constructing a new
                    Avitene finished goods manufacturing facility
                    in Woburn.

April 1994          MedChem U.S.A. substantially completes the
                    construction of that facility.
                          - 58 -

                        APPENDIX B

               PROCESSING AGREEMENT

     PROCESSING AGREEMENT dated as of December 18, 1987
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:

     1. Definitions. As used in this Agreement, the
following terms have the meanings set forth below:

          1.1 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.

          *    *    *     *    *      *   *

          1.4 Conversion Process -- the manufacturing
process by which raw materials are converted into the
finished Avitene product.

          *    *    *     *    *      *   *

          1.6 Delivery -- the delivery by Alcon [P.R.]
of Avitene processed under this Agreement.

          1.7 Equipment –- the machinery and equipment
owned by MedChem [P.R.] and required for the processing
of Avitene.

          1.8 Humacao Plant – Alcon[ P.R.]’s Avitene
processing facility in Humacao, Puerto Rico.

          *    *    *     *    *      *   *

          1.10 Order –- a writing from MedChem [P.R.]
authorizing or directing Alcon [P.R.] to process and
Deliver Avitene.
                        - 59 -

          1.11 Product Specifications -– the
specifications for Avitene set forth * * * [in a
referenced schedule].

          1.12 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.

           1.13 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 9.

          *    *    *    *    *    *    *

     2.   Processing.

          2.1 In General. Subject to the provisions
of Section 5, and in return for a Processing Fee as
defined in Section 9, 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 Section 5. In the event that MedChem[
P.R.]’s 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.

          2.2 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 * * *.
                        - 60 -

          2.3 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 Section 4 the right to use the
Equipment, without charge therefor. Alcon [P.R.] shall
furnish all labor, variable and fixed overhead and
quality 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 9). 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.] is 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.
                        - 61 -

     3.   License.

          3.1 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.

          3.2 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.

          3.3 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. * * *

          3.4 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 Section 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.].

     4. 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
                         - 62 -

precautions to preserve the physical condition of the
Equipment, and upon the termination of this Agreement
pursuant to Section 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.

     5.   Ordering Procedure.

          5.1 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 60 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 requirements for each
Avitene product for each calendar quarter or fraction
thereof during the period commencing on the date of
this Agreement and ending on December 31, 1988. * * *

          5.2 Subsequent Annual Forecast. No later
than August 15, 1988 and 1989, 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
November 30, 1988 and 1989.

          5.3 Annual Commitment. MedChem [P.R.] shall
order at least 80% of the Initial Forecast Amount or
the Current Annual Forecast Amount and Alcon [P.R.]
shall be required to process up to 250% 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 13, Alcon [P.R.]
agrees, upon reasonable notice to use good faith
efforts to process such reasonable amounts in excess of
250% of the Current Annual Forecast Amount during the
                         - 63 -

ninety (90) 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. * * *

          5.4 Orders and Quarterly Updates. Within a
reasonable time after the date of this Agreement, and
at least 15 days prior to January 1, April 1, July 1
and October 1 of each year thereafter, MedChem [P.R.]
shall furnish to Alcon [P.R.] (i) 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 30 days from the
date of receipt of such Order before such Delivery is
required, and (ii) 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 quantities which
Alcon [P.R.] is unable or unwilling to provide.

          5.5. 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.

          *     *    *    *    *    *   *

     6.   Packaging and Labeling.

          6.1 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
                         - 64 -

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.

          6.2 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 90 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 90 days prior written notice of such a
change.

     7.   Delivery; Storage.

          7.1 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.

          7.2   Storage; Related Documentation. At
MedChem[ P.R.]’s request and for so long as this
                         - 65 -

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.

     8.   Acceptance and Rejection of Avitene by MedChem
[P.R.].

          8.1 In General. Except as set forth below,
MedChem [P.R.] shall have the right, within 30 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
subsequent Delivery by Alcon [P.R.] of contaminated
Avitene.) [sic] * * *

          8.2 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.]. * * *

          8.3 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 (i) certifying that such
shipment, batch or lot of Avitene meets in every
material respect the Product Specifications and (ii)
specifying the results of Alcon[ P.R.]’s analysis of
such shipment, batch or lot.

          8.4 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.

          8.5 Notice; Return; Retesting; Replacement.
MedChem [P.R.] shall not be obligated to remit the
Processing Fee to Alcon [P.R.] for, and shall notify
                        - 66 -

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.]’s 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.

          8.6 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 9 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.

     9.   Payment.

          9.1 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 (10%). However, the Processing Fee will be
                        - 67 -

adjusted at year end to account for manufacturing
variances, which shall be calculated pursuant to the
terms of this Section 9.

     The Processing Fee shall be determined in two
steps. First, on or before December 31 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
10% 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 10% within 30 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 10% within 30 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.
                        - 68 -

          9.2 Option C Processing Fee. In addition to
the Processing Fee payable pursuant to Section 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
31 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
10% 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 10% within 30 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 10% within 30
days of the end of the year. MedChem [P.R.] shall have
                        - 69 -

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.

     10. Payment. MedChem [P.R.] shall pay Processing
Fees pursuant to Alcon[ P.R.]’s invoice for Avitene
Delivered under any Order within 30 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 8.5. Payment of any disputed amount (but
only to the extent of the disputed amount) shall be
deferred until resolution of such dispute.

     11.   Warranty.

          11.1 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.

          11.2 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 (i) any change required by
                        - 70 -

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, (ii)
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 Section 11.1
hereof and (iii) 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 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. 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.

          11.3 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 Section 11.1
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.
                             - 71 -

     12.   Term and Termination.

          12.1 Term of Agreement. The term of this
Agreement shall commence on the date hereof and shall
end on December 31, 1990 (unless sooner terminated
pursuant to this Section 12), and may be renewed on
terms and conditions mutually satisfactory to the
parties hereto.

           12.2   Insolvency. * * *

           12.3   Default.

               (a) In General. Except as otherwise
provided in this Section 12, either party, at its
option, may terminate this Agreement upon the
occurrence of any breach by the other party, provided
however (i) 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 60 days after receipt of the notice and (iii)
that the nonbreaching party must exercise its option to
terminate this Agreement within 60 days after the
expiration of the cure period.

               (b) Failure to Deliver by Alcon [P.R.].
Subject to the provisions of Section 12.3(c) 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,
(i) that MedChem [P.R.] shall have delivered to Alcon
[P.R.] a written notice of such failure to Deliver,
(ii) that Alcon [P.R.] shall have failed to make
Delivery within 60 days after receipt of such written
notice and (iii) that MedChem [P.R.] must exercise its
option to terminate this Agreement within 60 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.
                         - 72 -

               (c)   Force Majeure. * * *

          12.4 Establishment of MedChem [P.R.] Plant.
MedChem [P.R.] may terminate this Agreement pursuant to
the provisions of Section 13.

          12.5 Remedies Not Exclusive. In the event
of a breach of this Agreement, the rights of
termination provided in this Section 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 Sections 12.3(a) and (b).

          *    *     *    *    *    *       *

     13. 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
quality 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
                        - 73 -

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 December 31,
1990 upon at least ninety (90) days prior written
notice to Alcon [P.R.].
          *    *    *    *    *    *    *

     17. Applicable Law. The validity, performance
and construction of this Agreement shall be governed by
the laws of the Commonwealth of Massachusetts.

          *    *    *    *      *     *    *

     19. 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.
          6201 South Freeway
          Forth Worth, TX 76134
          Attention: Henry Meadows
                      Vice President and Controller
                      Surgical Specialty Division

          If to MedChem [P.R.]:

          MedChem Puerto Rico, Inc.
          43 Nagog Park
          Acton, MA 01720
          Attention: President

and shall be deemed given when received.

     20. 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.]. * * *

          *    *    *    *      *     *    *
                        - 74 -

     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