SCOTUS Reports

Tag: Active Conduct of a Trade or Business

  • Electronic Arts, Inc. & Subs. v. Comm’r, 118 T.C. 226 (2002): Possessions Tax Credits and Active Conduct of a Trade or Business

    Electronic Arts, Inc. & Subs. v. Comm’r, 118 T. C. 226 (2002), United States Tax Court, 2002.

    The U. S. Tax Court ruled that Electronic Arts Puerto Rico, Inc. (EAPR) actively conducted a trade or business in Puerto Rico, qualifying for possessions tax credits under section 936. However, the court denied EAPR’s use of the profit split method due to insufficient proof of manufacturing the video games in Puerto Rico, impacting the eligibility for tax benefits related to intangible property income.

    Parties

    Plaintiff: Electronic Arts, Inc. and Subsidiaries (EA), Electronic Arts Puerto Rico, Inc. (EAPR), both Delaware corporations, initially at trial and on appeal.

    Defendant: Commissioner of Internal Revenue, respondent at trial and on appeal.

    Facts

    EA developed and marketed interactive entertainment software. Before the years in issue, EA relied on unrelated manufacturers in Taiwan and Japan. In 1992, EA established EAPR to move manufacturing operations to Puerto Rico. EAPR entered into agreements with Power Parts, Inc. (PPI), leasing space, employees, and purchasing equipment, raw materials, and components from unrelated suppliers. EAPR sold the manufactured video games to EA. EAPR employed a manager who supervised PPI’s employees and managed materials and inventory control in Puerto Rico.

    Procedural History

    EA and EAPR moved for partial summary judgment in the U. S. Tax Court, asserting entitlement to possessions tax credits under section 936. They contended that EAPR actively conducted a trade or business in Puerto Rico and maintained a significant business presence, allowing them to use the profit split method. The Tax Court granted partial summary judgment on the active conduct issue but denied it on the profit split method issue, finding genuine material factual disputes regarding EAPR’s role as the manufacturer of the video games.

    Issue(s)

    Whether EAPR was engaged in the active conduct of a trade or business in Puerto Rico under section 936(a)(2)(B), and whether EAPR had a significant business presence in Puerto Rico to use the profit split method under section 936(h)(5)(B)?

    Rule(s) of Law

    Section 936(a)(2)(B) requires that at least 75% of the corporation’s gross income be derived from the active conduct of a trade or business within a U. S. possession. Section 936(h)(5)(B) allows an election out of certain intangible property income rules if the corporation has a significant business presence in the possession, defined by specific tests including manufacturing within the meaning of section 954(d)(1)(A).

    Holding

    The Tax Court held that EAPR was engaged in the active conduct of a trade or business in Puerto Rico, thus qualifying for possessions tax credits under section 936(a)(2)(B). However, the court denied EAPR’s motion for partial summary judgment on the issue of significant business presence under section 936(h)(5)(B), finding that EAPR failed to show it manufactured the video games in Puerto Rico within the meaning of section 954(d)(1)(A).

    Reasoning

    The court’s reasoning on the active conduct issue relied on precedents such as MedChem (P. R. ), Inc. v. Commissioner and Western Hemisphere Trading Corporation cases, concluding that EAPR’s activities in Puerto Rico, including ownership of equipment and materials, leasing of space, and supervision by its manager, satisfied the active conduct test. The court rejected the Commissioner’s argument against attribution of activities to EAPR, emphasizing that the facts were sufficient to establish active conduct.

    On the significant business presence issue, the court analyzed the legislative history of section 936(h) and section 954(d)(1)(A), concluding that EAPR met the first prong of the test by satisfying the direct labor test. However, the court found genuine disputes over whether EAPR was the manufacturer of the video games under the second prong, requiring further factual development before determining eligibility for the profit split method.

    Disposition

    The Tax Court granted EA and EAPR’s motion for partial summary judgment on the active conduct issue but denied it on the significant business presence issue related to the profit split method.

    Significance/Impact

    The decision clarifies the criteria for qualifying for possessions tax credits under section 936, particularly emphasizing the requirement for active conduct of a trade or business in a U. S. possession. It also highlights the complexities of proving manufacturing within the meaning of section 954(d)(1)(A) for tax purposes, impacting how corporations structure operations in U. S. possessions to maximize tax benefits. The ruling has implications for other corporations seeking similar tax credits, underscoring the need for a substantial business presence and active involvement in the manufacturing process.

  • MedChem (P.R.), Inc. v. Commissioner, 116 T.C. 308 (2001): Active Conduct of a Trade or Business Under IRC Section 936

    MedChem (P. R. ), Inc. v. Commissioner, 116 T. C. 308 (2001)

    In MedChem (P. R. ), Inc. v. Commissioner, the U. S. Tax Court ruled that MedChem (P. R. ), Inc. did not qualify for a tax credit under IRC Section 936 because it failed to actively conduct a trade or business in Puerto Rico. The court found that MedChem (P. R. ) did not participate regularly, continually, extensively, and actively in the management and operation of the Avitene manufacturing business, despite outsourcing production to Alcon P. R. This decision clarifies the requirements for the active conduct of a trade or business in U. S. possessions for tax credit eligibility.

    Parties

    MedChem (P. R. ), Inc. and MedChem Products, Inc. were the petitioners, with MedChem (P. R. ), Inc. initially filing as a wholly owned subsidiary of MedChem Products, Inc. The Commissioner of Internal Revenue was the respondent. The case was heard in the U. S. Tax Court.

    Facts

    MedChem Products, Inc. (MedChem U. S. A. ) is a Massachusetts corporation that acquired the Avitene business from Alcon Puerto Rico Inc. (Alcon P. R. ) and related entities on December 18, 1987. MedChem (P. R. ), Inc. , a wholly owned subsidiary of MedChem U. S. A. , was established to facilitate the transaction. Under the agreements, Alcon P. R. continued to manufacture Avitene, a blood clotting drug, using MedChem (P. R. )’s raw materials and equipment in its Puerto Rico facility. MedChem (P. R. ) had no employees after June 30, 1990, and all its officers and directors were also officers and/or directors of MedChem U. S. A. , based in Woburn, Massachusetts. MedChem (P. R. ) attempted to build its own manufacturing facility in Puerto Rico but abandoned the project following financial difficulties related to another product, Amvisc, and moved the Avitene manufacturing process to MedChem U. S. A. ‘s facility in Woburn.

    Procedural History

    The Commissioner determined deficiencies in MedChem (P. R. ), Inc. ‘s and MedChem Products, Inc. ‘s federal income taxes for the fiscal year ending August 31, 1992, asserting that MedChem (P. R. ), Inc. did not meet the requirements for the Puerto Rico and possession tax credit under IRC Section 936. The cases were submitted to the U. S. Tax Court without trial and were consolidated. The standard of review applied was de novo, with the burden of proof on the petitioners.

    Issue(s)

    Whether MedChem (P. R. ), Inc. met the “active conduct of a trade or business within a possession” requirement of IRC Section 936(a)(2)(B) by virtue of the activities of Alcon P. R. in Puerto Rico, the use of MedChem (P. R. )’s raw materials and equipment, the continuous ownership of raw materials by MedChem (P. R. ), and the payment of labor costs to MedChem U. S. A. and Alcon P. R. ?

    Rule(s) of Law

    IRC Section 936(a) allows a domestic corporation to claim a tax credit for its income derived from sources within a U. S. possession, provided it meets certain conditions. Specifically, Section 936(a)(2)(B) requires that 75 percent or more of the corporation’s gross income for the 3-year period immediately preceding the close of the taxable year be derived from the active conduct of a trade or business within a U. S. possession.

    Holding

    The U. S. Tax Court held that MedChem (P. R. ), Inc. did not meet the “active conduct of a trade or business within a possession” requirement of IRC Section 936(a)(2)(B). The court found that MedChem (P. R. ), Inc. did not participate regularly, continually, extensively, and actively in the management and operation of a profit-motivated activity in Puerto Rico.

    Reasoning

    The court analyzed the phrase “active conduct of a trade or business” by reference to the Secretary’s definitions of similar phrases for other purposes of the Internal Revenue Code and the legislative history of Section 936. The court determined that to qualify for the tax credit, a taxpayer must participate meaningfully in the management and operation of a profit-motivated activity in the possession, and that the services underlying a manufacturing contract may be imputed to a taxpayer only to the extent that they are adequately supervised by the taxpayer’s own employees. The court found that MedChem (P. R. ), Inc. ‘s involvement in Puerto Rico was minimal, with no operational or directional control over the Avitene business, which was directed by Alcon P. R. and MedChem U. S. A. The court rejected MedChem (P. R. ), Inc. ‘s argument that it actively conducted a trade or business in Puerto Rico based on its ownership of raw materials and equipment and the use of a contract manufacturer.

    Disposition

    The court decided that decisions would be entered under Rule 155, indicating that the case would proceed to a computation of the tax deficiencies owed by MedChem (P. R. ), Inc. and MedChem Products, Inc.

    Significance/Impact

    The MedChem (P. R. ), Inc. case is significant for clarifying the requirements for the active conduct of a trade or business in a U. S. possession under IRC Section 936. The decision underscores that mere ownership of assets used in a business or the use of a contract manufacturer is insufficient to meet the active conduct requirement. This ruling impacts how corporations structure their operations in U. S. possessions to qualify for tax incentives and has implications for tax planning and compliance in such jurisdictions. The case also highlights the importance of substantial involvement in the management and operation of the business within the possession to claim the tax credit.

  • King v. Commissioner, 55 T.C. 677 (1971): When Subsidiary’s Activities Do Not Constitute ‘Active Conduct of a Trade or Business’

    King v. Commissioner, 55 T. C. 677 (1971)

    A subsidiary’s activities do not constitute the ‘active conduct of a trade or business’ under section 355 if it merely holds and leases property to its parent on a net lease basis.

    Summary

    Mason & Dixon Lines, Inc. , distributed the stock of its subsidiaries, Interstate, Motorways, and Regal, to its shareholders. These subsidiaries solely leased motor freight terminals to Mason & Dixon on a net lease basis. The IRS determined that this distribution was a taxable dividend because the subsidiaries were not engaged in the active conduct of a trade or business during the five years prior to the distribution, as required by section 355. The Tax Court upheld this determination, ruling that the subsidiaries’ passive leasing activities, lack of employees, and complete dependence on Mason & Dixon did not meet the ‘active conduct’ requirement.

    Facts

    Mason & Dixon Lines, Inc. , was a motor freight carrier that owned all the stock of three subsidiaries: Interstate Investment Corp. , Motorways Investment Corp. , and Regal Corp. These subsidiaries were formed to acquire, construct, and lease motor freight terminals to Mason & Dixon on a net lease basis, where Mason & Dixon paid all expenses. The subsidiaries had no employees other than a shared accountant and relied on Mason & Dixon for all operational and decision-making activities. On October 4, 1963, Mason & Dixon distributed the stock of these subsidiaries to its shareholders, who then exchanged the stock for shares in Crown Enterprises, Inc.

    Procedural History

    The IRS determined deficiencies in the petitioners’ 1963 federal income taxes, treating the distribution as a taxable dividend. The petitioners contested this in the U. S. Tax Court, arguing that the distribution qualified for nonrecognition of gain under section 355 of the Internal Revenue Code. The Tax Court consolidated multiple cases involving various shareholders of Mason & Dixon and ruled in favor of the Commissioner.

    Issue(s)

    1. Whether the distribution of the stock of Interstate, Motorways, and Regal by Mason & Dixon to its shareholders qualified for nonrecognition of gain under section 355 of the Internal Revenue Code.

    Holding

    1. No, because Interstate, Motorways, and Regal were not engaged in the active conduct of a trade or business during the five-year period prior to the distribution as required by section 355(b).

    Court’s Reasoning

    The court applied the requirement under section 355(b) that both the distributing and controlled corporations must have been engaged in the active conduct of a trade or business immediately after and for the five years prior to the distribution. The court found that the subsidiaries’ activities did not meet this requirement because:

    • They had no employees of their own and relied on Mason & Dixon for all operational activities.
    • Their income was solely from net leases to Mason & Dixon, which is considered passive income.
    • They did not seek tenants other than Mason & Dixon.
    • Property acquisition, construction, and financing were handled by Mason & Dixon employees.

    The court emphasized that the subsidiaries’ dependence on Mason & Dixon for all business functions and the passive nature of their income did not constitute the active conduct of a trade or business. The court distinguished this case from others where subsidiaries had additional income sources or were actively involved in the management of their assets.

    Practical Implications

    This decision impacts how corporate distributions involving subsidiary companies are analyzed for tax purposes:

    • It clarifies that merely holding and leasing property to a parent company on a net lease basis does not qualify as the active conduct of a trade or business under section 355.
    • Corporate planners must ensure that subsidiaries have independent operations and employees to meet the active conduct requirement if they wish to qualify for nonrecognition of gain under section 355.
    • Businesses must carefully consider the operational independence of subsidiaries when planning corporate restructurings to avoid unintended tax consequences.
    • Subsequent cases have cited King v. Commissioner to distinguish situations where subsidiaries engage in more active business activities, such as managing properties or engaging in other business operations beyond passive leasing.