Termination of Puerto Rico & Possession Tax Credit;
New Lines of Business Prohibited

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8868] RIN 1545-AV68

TITLE: Termination of Puerto Rico and Possession Tax Credit; New
Lines of Business Prohibited

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document amends the Income Tax Regulations by removing
temporary regulations that provide guidance regarding the addition
of a substantial new line of business by a possessions corporation
that is an existing credit claimant and adding final regulations.
These regulations are necessary to implement changes made by the
Small Business Job Protection Act of 1996.

DATES: Effective Date. These regulations are effective January 25,
2000.

FOR FURTHER INFORMATION CONTACT: Daniel S. Karen, (202) 874- 1490,
or Jacob Feldman, (202) 622-3830 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 1601(a) of the Small Business Job Protection Act of 1996,
Public Law 104-188, 110 Stat. 1755 (1996), amended the Internal
Revenue Code by adding section 936(j). Section 936(j) generally
repeals the Puerto Rico and possession tax credit for taxable years
beginning after December 31, 1995. However, the section provides
grandfather rules under which a corporation that is an existing
credit claimant would be eligible to claim credits for a transition
period. The Puerto Rico and possession tax credit and the Puerto
Rico economic activity credit phase out for these existing credit
claimants ending with the last taxable year beginning before January
1, 2006.

For taxable years beginning after December 31, 1995 and before
January 1, 2006, the Puerto Rico and possession tax credit and the
Puerto Rico economic activity credit apply only to a corporation
that qualifies as an existing credit claimant (as defined in section
936(j)(9)(A)). The determination of whether a corporation is an
existing credit claimant is made separately for each possession. A
possessions corporation that adds a substantial new line of business
(other than in a qualifying acquisition of all the assets of a trade
or business of an existing credit claimant) after October 13, 1995,
ceases to be an existing credit claimant as of the beginning of the
taxable year during which such new line of business is added.
Therefore, a possessions corporation that ceases to be an existing
credit claimant either because it has added a substantial new line
of business, or because a new line of business becomes substantial,
during a taxable year may not claim the Puerto Rico and possession
tax credit or the Puerto Rico economic activity credit for that
taxable year or any subsequent taxable year.

On August 19, 1998, temporary regulations were published in the
Federal Register (63 FR 44387). A cross referenced Notice of
Proposed Rulemaking was also published in the Federal Register (63
FR 44416) on the same date. Three comments were received with
respect to the Notice. No hearing was requested and none was held.
The temporary regulations are, therefore, adopted as proposed with
the following changes, as explained, below.

Explanation of Revisions and Summary of Comments. Minor and
conforming changes were made in these final regulations. Several
changes were also made in the final regulations with regard to the
three comments that were received on the Notice of Proposed
Rulemaking.

The first comment received addressed the issue as to whether the
leasing of some of the assets of an existing credit claimant would
result in a new line of business under section 936(j)(9)(B) with
respect to the leasing activity. In response to the comment, the
final regulations provide that the leasing out of assets by an
existing credit claimant (and the employees necessary to operate the
leased assets) will not be treated as a new line of business
provided that (1) the existing credit claimant used the leased
assets in an active trade or business for at least five years, (2)
the existing credit claimant does not through its own officers or
staff of employees perform management or operational functions (but
not including operational functions performed through leased
employees) with respect to the leased assets, and (3) the existing
credit claimant does not perform marketing functions with respect to
the leasing of the assets. The income from the leasing of assets
will not be income from the active conduct of a trade or business,
and therefore, the existing credit claimant may not receive a
possession tax credit with respect to such income.

A second comment asked for clarification as to whether a taxpayer
seeking to be treated as an existing credit claimant through the
acquisition of the assets of an existing credit claimant pursuant to
section 936(j)(9)(A)(ii) must acquire all the assets of the acquired
corporation even in cases in which the existing credit claimant has
more than one trade or business.

The final regulations have been clarified to conform to the language
of section 936(j)(9)(A)(ii) and provide that an acquiring
corporation need only acquire all the assets of a single trade or
business to be treated as an existing credit claimant.

The third comment asked for clarification as to when the assets of a
trade or business are measured for purposes of satisfying the
requirement that all the assets of a trade or business must be
acquired from an existing credit claimant in order to satisfy
section 936(j)(9)(A)(ii). Specifically, the comment expressed
concern that assets of an existing credit claimant may be sold or
otherwise disposed of between October 13, 1995, the date on which
existing credit claimant status is established, and the date of
acquisition. In response to the comment, the final regulations
provide that the assets of a trade or business of an existing credit
claimant are determined on the date of acquisition provided that the
transferee actively conducts a trade or business in the possession
with the acquired assets.

Special Analyses

It has been determined that this final regulation is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to this regulation, and because
the regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does
not apply. Pursuant to section 7805(f) of the Internal Revenue Code,
the preceding notice of proposed rulemaking was submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on its effect on small business.

Drafting Information

The principal author of this regulation is Daniel S. Karen of the
Office of the Associate Chief Counsel (International), within the
office of Chief Counsel, IRS. However, other personnel from the IRS
and the Department of the Treasury participated in the development
of this regulation.

List of Subjects

26 CFR Part 1.6

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
removing the entry for 1.936-11T and by adding an entry in numerical
order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.936-11 also issued under 26 U.S.C. 936(j). * * *

§1.936-11T [Removed] Par. 2. Section 1.936-11T is removed. Par. 3.
Section 1.936-11 is added to read as follows: §1.936-11 New lines of
business prohibited.

(a) In general. A possessions corporation that is an existing credit
claimant, as defined in section 936(j)(9)(A) and this section, that
adds a substantial new line of business during a taxable year, or
that has a new line of business that becomes substantial during the
taxable year, loses its status as an existing credit claimant for
that year and all years subsequent.

(b) New line of business--(1) In general. A new line of business is
any business activity of the possessions corporation that is not
closely related to a pre-existing business of the possessions
corporation. The term closely related is defined in paragraph (b)(2)
of this section. The term pre-existing business is defined in
paragraph (b)(3) of this section.

(2) Closely related. To determine whether a new activity is closely
related to a pre-existing business of the possessions corporation
all the facts and circumstances must be considered, including those
set forth in paragraphs(b)(2)(i)(A) through (G) of this section.

(i) Factors. The following factors will help to establish that a new
activity is closely related to a pre-existing business activity of
the possessions corporation--

(A) The new activity provides products or services very similar to
the products or services provided by the pre-existing business;

(B) The new activity markets products and services to the same class
of customers;

(C) The new activity is of a type that is normally conducted in the
same business location;

(D) The new activity requires the use of similar operating assets;

(E) The new activity's economic success depends on the success of
the pre-existing business;

(F) The new activity is of a type that would normally be treated as
a unit with the pre-existing business in the business' accounting
records; and

(G) The new activity and the pre-existing business are regulated or
licensed by the same or similar governmental authority.

(ii) Safe harbors. An activity is not a new line of business if--

(A) If the activity is within the same six-digit North American
Industry Classification System (NAICS) code (or four-digit Standard
Industrial Classification (SIC) code). The similarity of the NAICS
or SIC codes may not be relied upon to determine whether the
activity is closely related to a pre-existing business where the
code indicates a miscellaneous category;

(B) If the new activity is within the same five-digit NAICS code (or
three-digit SIC code) and the facts relating to the new activity
also satisfy at least three of the factors listed in paragraphs (b)
(2)(i)(A) through (G) of this section; or

(C) If the pre-existing business is making a component product or
end-product form, as defined in §1.936-5(a)(1),Q&A1, and the new
business activity is making an integrated product, or an end-product
form with fewer excluded components, that is not within the same
six-digit NAICS code (or four-digit SIC code) as the pre-existing
business solely because the component product and the integrated
product (or two end-product forms) have different end-uses.

(3) Pre-existing business--(i) In general. Except as provided in
paragraph (b)(3)(ii) of this section, a business activity is a pre-
existing business of the existing credit claimant if--

(A) The existing credit claimant was actively engaged in the
activity within the possession on or before October 13, 1995; and

(B) The existing credit claimant had elected the benefits of the
Puerto Rico and possession tax credit pursuant to an election which
was in effect for the taxable year that included October 13, 1995.

(ii) Acquisition of an existing credit claimant. (A) If all the
assets of one or more trades or businesses of a corporation of an
existing credit claimant are acquired by an affiliated or non-
affiliated existing credit claimant which carries on the business
activity of the predecessor existing credit claimant, the acquired
business activity will be treated as a pre-existing business of the
acquiring corporation. A non-affiliated acquiring corporation will
not be bound by any section 936(h) election made by the predecessor
existing credit claimant with respect to that business activity.

(B) Where all of the assets of one or more trades or businesses of a
corporation of an existing credit claimant are acquired by a
corporation that is not an existing credit claimant, the acquiring
corporation may make a section 936(e) election for the taxable year
in which the assets are acquired with the following effects--

(1) The acquiring corporation will be treated as an existing credit
claimant for the year of acquisition;

(2) The activity will be considered a pre-existing business of the
acquiring corporation;

(3) The acquiring corporation will be deemed to satisfy the rules of
section 936(a)(2) for the year of acquisition; and

(4) After making an election under section 936(e), a non-affiliated
acquiring corporation will not be bound by elections under sections
936(a)(4) and (h) made by the predecessor existing credit claimant.

(C) For purposes of this section the assets of a trade or business
are determined at the time of acquisition provided that the
transferee actively conducts the trade or business acquired.

(D) A mere change in the stock ownership of a possessions
corporation will not affect its status as an existing credit
claimant for purposes of this section.

(4) Leasing of Assets.--(i) The leasing of assets (and employees to
operate leased assets) will not, for purposes of this section, be
considered a new line of business of the existing credit claimant
if--

(A) the existing credit claimant used the leased assets in an active
trade or business for at least five years;

(B) the existing credit claimant does not through its own officers
or staff of employees perform management or operational functions
(but not including operational functions performed through leased
employees) with respect to the leased assets; and

(C) the existing credit claimant does not perform marketing
functions with respect to the leasing of the assets.

(ii) Any income from the leasing of assets not considered a new line
of business pursuant to paragraph (b)(4)(i) of this section will not
be income from the active conduct of a trade or business (and,
therefore, the existing credit claimant may not receive a possession
tax credit with respect to such income).

(5) Timing rule. The tests for a new line of business in this
paragraph (whether the new activity is closely related to a pre-
existing business) are applied only at the end of the taxable year
during which the new activity is added.

(c) Substantial--(1) In general. A new line of business is
considered to be substantial as of the earlier of--

(i) The taxable year in which the possessions corporation derives
more than 15 percent of its gross income from that new line of
business (gross income test); or

(ii) The taxable year in which the possessions corporation directly
uses in that new line of business more than 15 percent of its assets
(assets test).

(2) Gross income test. The denominator in the gross income test is
the amount that is the gross income of the possessions corporation
for the current taxable year, while the numerator is the amount that
is the gross income of the new line of business for the current
taxable year. The gross income test is applied at the end of each
taxable year. For purposes of this test, if a new line of business
is added late in the taxable year, the income is not to be
annualized in that year. In the case of a new line of business
acquired through the purchase of assets, the gross income of such
new line of business for the taxable year of the acquiring
corporation that includes the date of acquisition is determined from
the date of acquisition through the end of the taxable year. In the
case of a consolidated group election made pursuant to section
936(i)(5), the test applies on a company by company basis and not on
a consolidated basis.

(3) Assets test--(i) Computation. The denominator is the adjusted
tax basis of the total assets of the possessions corporation for the
current taxable year. The numerator is the adjusted tax basis of the
total assets utilized in the new line of business for the current
taxable year. The assets test is computed annually using all assets
including cash and receivables.

(ii) Exception. A new line of business of a possessions corporation
will not be treated as substantial as a result of meeting the assets
test if an event that is not reasonably anticipated causes assets
used in the new line of business of the possessions corporation to
exceed 15 percent of the adjusted tax basis of the possessions
corporation's total assets. For example, an event that is not
reasonably anticipated would include the destruction of plant and
equipment of the pre-existing business due to a hurricane or other
natural disaster, or other similar circumstances beyond the control
of the possessions corporation. The expiration of a patent is not
such an event and will not permit use of this exception.

(d) Examples. The following examples illustrate the rules described
in paragraphs (a), (b), and (c) of this section. In the following
examples, X Corp. is an existing credit claimant unless otherwise
indicated:

Example 1. X Corp. is a pharmaceutical corporation which
manufactured bulk chemicals (a component product). In March 1997, X
Corp. began to also manufacture pills (e.g., finished dosages or an
integrated product). The new activity provides products very similar
to the products provided by the pre-existing business. The new
activity is of a type that is normally conducted in the same
business location as the pre-existing business. The activity's
economic success depends on the success of the pre-existing
business. The manufacture of bulk chemicals is in NAICS code 325411,
Medicinal and Botanical Manufacturing, while the manufacture of the
pills is in NAICS code 325412, Pharmaceutical Preparation
Manufacturing. Although the products have a different end-use, may
be marketed to a different class of customers, and may not use
similar operating assets, they are within the same five-digit NAICS
code and the activity also satisfies paragraphs (b)(2)(i)(A), (C),
and (E) of this section. The manufacture of the pills by X Corp.
will be considered closely related to the manufacture of the bulk
chemicals. Therefore, X Corp. will not be considered to have added a
new line of business for purposes of paragraph (b) of this section
because it falls within the safe harbor rule of (b)(2)(ii)(B).

Example 2. X Corp. currently manufactures printed circuit boards in
a possession. As a result of a technological breakthrough, X Corp.
could produce the printed circuit boards more efficiently if it
modified its existing production methods. Because demand for its
products was high, X Corp. expanded when it modified its production
methods. After these modifications to the facilities and production
methods, the products produced through the new technology were in
the same six-digit NAICS code as products produced previously by X
Corp. See paragraph (b)(2)(ii)(A) of this section. Therefore, X
Corp. will not be considered to have added a new line of business
for purposes of paragraph (b) of this section because it falls
within the safe harbor rule of (b)(2)(ii)(A).

Example 3. X Corp. has manufactured Device A in Puerto Rico for a
number of years and began to manufacture Device B in Puerto Rico in
1997. Device A and Device B are both used to conduct electrical
current to the heart and are both sold to cardiologists. There is no
significant change in the type of activity conducted in Puerto Rico
after the transfer of the manufacturing of Device B to Puerto Rico.
Similar manufacturing equipment, manufacturing processes and skills
are used in the manufacture of both devices. Both are regulated and
licensed by the Food and Drug Administration. The economic success
of Device B is dependent upon the success of Device A only to the
extent that the liability and manufacturing prowess with respect to
one reflects favorably on the other. Depending upon the heart
abnormality, the cardiologist may choose to use Device A, Device B
or both on a patient. The manufacture of Device B is treated as a
unit with the manufacture of Device A in X Corp.'s accounting
records. The manufacture of Device A is in the six-digit NAICS code
339112, Surgical and Medical Instrument Manufacturing. The
manufacture of Device B is in the six-digit NAICS code 334510,
Electromedical and electrotherapeutic Apparatus Manufacturing. (The
manufacture of Device A is in the four-digit SIC code 3845,
Electromedical and Electrotherapeutic Apparatus. The manufacture of
Device B is in the four-digit SIC code 3841, Surgical and Medical
Instruments and Apparatus.) The safe harbor of paragraph (b)(2)(ii)
(B) of this section applies because the two activities are within
the same three-digit SIC code and Corp. X satisfies paragraphs (b)
(2)(i)(A), (B), (C), (D), (F), and (G) of this section.

Example 4. X Corp. has been manufacturing house slippers in Puerto
Rico since 1990. Y Corp. is a U.S. corporation that is not
affiliated with X Corp. and is not an existing credit claimant. Y
Corp. has been manufacturing snack food in the United States. In
1997, X Corp. purchased the assets of Y Corp. and began to
manufacture snack food in Puerto Rico. House slipper manufacturing
is in the six-digit NAICS code 316212 (Four-digit SIC code 3142,
House Slippers). The manufacture of snack foods falls under the six-
digit NAICS code 311919, Other Snack Food Manufacturing (four-digit
SIC code 2052, Cookies and Crackers (pretzels)). Because these
activities are not within the same five or six digit NAICS code (or
the same three or four-digit SIC code), and because snack food is
not an integrated product that contains house slippers, the safe
harbor of paragraph (b)(2)(ii) of this section cannot apply.
Considering all the facts and circumstances, including the seven
factors of paragraph (b)(2)(i) of this section, the snack food
manufacturing activity is not closely related to the manufacture of
house slippers, and is a new line of business, within the meaning of
paragraph (b) of this section.

Example 5. X Corp., a calendar year taxpayer, is an existing credit
claimant that has elected the profit-split method for computing
taxable income. P Corp. was not an existing credit claimant and
manufactured a product in a different five-digit NAICS code than the
product manufactured by X Corp. In 1997, X Corp. acquired the stock
of P Corp. and liquidated P Corp. in a tax-free liquidation under
section 332, but continued the business activity of P Corp. as a new
business segment. Assume that this new business segment is a new
line of business within the meaning of paragraph (c) of this
section. In 1997, X Corp. has gross income from the active conduct
of a trade or business in a possession computed under section 936(a)
(2) of $500 million and the adjusted tax basis of its assets is $200
million. The new business segment had gross income of $60 million,
or 12 percent of the X Corp. gross income, and the adjusted basis of
the new segment's assets was $20 million, or 10 percent of the X
Corp. total assets. In 1997, X Corp. does not derive more than 15
percent of its gross income, or directly use more that 15 percent of
its total assets, from the new business segment.

Thus, the new line of business acquired from P Corp. is not a
substantial new line of business within the meaning of paragraph (c)
of this section, and the new activity will not cause X Corp. to lose
its status as an existing credit claimant during 1997. In 1998,
however, the gross income of X Corp. grew to $750 million while the
gross income of the new line of business grew to $150 million, or
20% of the X Corp. 1998 gross income. Thus, in 1998, the new line of
business is substantial within the meaning of paragraph (c) of this
section, and X Corp. loses its status as an existing credit claimant
for 1998 and all years subsequent.

(e) Loss of status as existing credit claimant. An existing credit
claimant that adds a substantial new line of business in a taxable
year, or that has a new line of business that becomes substantial in
a taxable year, loses its status as an existing credit claimant for
that year and all years subsequent.

(f) Effective date--(1) General rule. This section applies to
taxable years of a possessions corporation beginning on or after
January 25, 2000..(2) Election for retroactive application.
Taxpayers may elect to apply retroactively all the provisions of
this section for any open taxable year beginning after December 31,
1995. Such election will be effective for the year of the election
and all subsequent taxable years. This section will not apply to
activities of pre-existing businesses for taxable years beginning
before January 1, 1996.

David Mader,
Acting Deputy Commissioner of Internal Revenue
Approved:
Jonathan Talisman,
Acting Assistant Secretary of the Treasury

SEARCH:

You can search the entire Tax Professionals section, or all of Uncle Fed's Tax*Board. For a more focused search, put your search word(s) in quotes.

2000 Regulations Main | IRS Regulations Main | Home