The Possession Tax Credit Under Section 936 (Portfolio 933)

Tax Management Portfolio, The Possession Tax Credit Under Section 936, discusses the provisions of §936, which allows a credit to domestic corporations for certain business activities in Puerto Rico and the U.S. possessions.

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This Portfolio examines, inter alia, the requirements for qualification as a possession corporation (i.e., a U.S. corporation that qualifies for the Puerto Rico and possession tax credit), the tax aspects of doing business as a possession corporation, and the effect of possession corporation status on its shareholders. The Portfolio addresses the intercompany transfer pricing problems that confront possession corporations and their shareholders and affiliates, and provides a detailed discussion of some historic, complex, transfer pricing litigation concerning income from intangible property in the context of Puerto Rico. There is also a review of the history of the U.S. and Puerto Rican tax incentive systems. Finally, the Portfolio discusses the very significant changes made to the possession corporation tax regime by the Revenue Reconciliation Act of 1993, which imposed major limitations on the operation of §936, and the Small Business Job Protection Act of 1996, which repealed §936 subject to a lengthy transitional period.


The Possession Tax Credit Under Section 936 was authored by the following experts.
Ernest F. Aud, Jr., Esq.

Ernest F. Aud, Jr., Esq., Ernst & Young LLP, Chicago, Illinois. B.B.A., University of Notre Dame (1965); J.D., Indiana University (1968); member, Indiana Bar; Certified Public Accountant (Illinois and Indiana); frequent lecturer and author of articles on international taxation and intercompany pricing, and member, World Trade Institute Tax Advisory Panel.

Murray Gordon, Esq.

Murray Gordon, Esq., Ernst & Young LLP, Chicago, Illinois. B.A. (cum laude), Brandeis University (1970); J.D., Loyola University (1975); LL.M. (Taxation), New York University (1976); member, Illinois Bar; Certified Public Accountant (Illinois); frequent lecturer on domestic and international corporate taxation, and member, World Trade Institute Tax Advisory Panel.

David M. Benson, Esq.

David M. Benson, Esq., Ernst & Young LLP, Washington, D.C. B.B.A., George Washington University (1971); J.D., Brooklyn Law School (1974); member, District of Columbia Bar; former Chair, AICPA International Tax Committee; formerly Technical Advisor to Associate Chief Counsel (Technical), Internal Revenue Service, Washington, D.C.; regular contributor to Tax Management International Journal.

Table of Contents

Detailed Analysis

I. Introduction

Introductory Material

A. Section 936 Prior to the 1993 RRA

B. Limitations on the § 936 Credit Imposed by the 1993 RRA

C. Phaseout of the § 936 Credit Under the 1996 Act

D. Section 30A, Enacted by the 1996 Act

II. Section 936 Prior to the 1993 RRA - In General

A. Overview

B. Background

1. Philosophy of the Credit

2. Operation of Pre-§ 936 Law

3. Original Enactment of § 936

4. Revenue Act of 1978

5. Tax Equity and Fiscal Responsibility Act of 1982

6. Tax Reform Act of 1986 Changes

7. Technical and Miscellaneous Revenue Act of 1988 Revisions

C. Qualifying as a Possession Corporation

1. General

2. The 80% and 75% Tests

3. Eligible Possessions

D. U.S. Taxation of the Possession Corporation and its Shareholders

1. Amount of the Credit

2. Amounts Received in the United States

3. Relation to the Foreign Tax Credit

4. Start-Up Losses

a. Excess Loss Accounts

b. Dual Consolidated Loss Rules

5. Qualified Possession Source Investment Income

6. Sale of Substantially All the Assets

7. Taxation of Distributions to Shareholders of a Possession Corporation

a. In General

b. Alternative Minimum Tax Rules

E. Investment in Qualified Caribbean Basin Countries

1. Overview

2. General Rule

3. Qualified Financial Institutions

4. Investments in Active Business Assets

a. Expenditures

b. Qualified Business Activity

5. Qualified Assets

6. Investments in Development Projects

a. In General

b. Public Use Requirement

7. Prompt Application of Borrowed Proceeds

8. Financing of Previously Incurred Costs

a. Projects That Are Not Long-Term

b. Long-Term Projects

c. Other Rules

9. Loans Through Financial Intermediaries

10. Qualified Recipient

11. Rules for Determining the Place of an Investment

12. Qualified Caribbean Basin Country

13. Agreements and Certifications by Qualified Recipients and Financial Intermediaries

a. Qualified Recipients

b. Financial Intermediaries

14. Statutory Certification Requirement

15. Continuing Due Diligence Requirements

16. Qualified Privatization

17. Termination of Qualified Investment Status

a. In General

b. Timely Cure

c. Assumption of the Obligation of a Qualified Recipient

III. Intercompany Pricing - General Rule

A. Overview

1. General Treatment of Income from Intangible Property

2. Historical Perspective

3. Eli Lilly and Co.

a. Background

b. The Facts and Tax Count Decision in Lilly

c. Section 482 Allocation v. Section 351 Transfer of Manufacturing Intangibles

d. Arm's Length Consideration

e. Burden of Proof

f. Determination of Arm's Length Prices

g. Comparable Uncontrolled Price - 1973

h. Seventh Circuit Decision

i. Conclusion

4. G.D. Searle

5. 1982 Legislation

B. The General Pricing Rule

1. Treatment of Intangible Property Income

2. Definition of Intangible Property Income

3. Allowance of Reasonable Markup on Costs of Possession Corporation

4. Absence of Intangible Property Income

IV. Intercompany Pricing - Elective Alternatives to the General Rule

A. Overview

B. Definitions of Affiliated Group and Related Person

1. Affiliated Group

2. Related Person

C. Definition of Product

1. Form of Product in General

2. Consistent Application of Product Definition

3. Products Sold at Different Production Stages and Export Sales

4. Unsold Inventory

5. Grouping Rules

6. Annual Designation

D. Significant Business Presence Test

1. The 25% Value-Added Test

2. The 65% Direct Labor Test

3. The Construction Test

4. Treatment of Components

a. Components Acquired from Affiliates

b. Components Acquired from Nonaffiliates

5. Contract Manufacturing

a. Definition of Contract Manufacturing

b. Effect of Contract Manufacturing Within the Possession

c. Effect of Contract Manufacturing Outside the Possession

6. Start-Up Operations

7. Interim Period Rules

E. Cost Sharing Alternative

1. In General

2. Treatment of Manufacturing and Marketing Intangibles

3. The Cost Sharing Payment

4. Application of Commensurate-with-Income Standard to Cost Sharing Payment

5. Definition of Terms

6. Credits Against Cost Sharing Payment

7. Determination of Taxable Income of the Possession Corporation

8. Determining Arm's Length Prices for Sales of Possession Products to Affiliates

9. Return on Covered Intangibles

10. Leasing Rules: Internal Consumption

F. Profit Split Alternative

1. In General

2. Determining the Profit Earned by the Possession Corporation

3. Incomplete Transactions

4. Computing the Gross Income of the Possession Corporation

5. Inventory Pricing Rules

G. Leasing or Internal Consumption of the Possession Product

1. Overview

2. Application of the Cost Sharing Method

3. Application of the Profit Split Method

H. Electing One of the Optional Pricing Methods

1. Change by Amended Return

2. Change While Under Examination or for Post-Examination Years

3. Required Adjustments

4. Distributions to Meet Qualification Requirements

5. Special Rule

I. Separate Election for Export Sales

J. Revocation of Election of Possession Corporation Status

K. Interaction with Foreign Sales Corporation (FSC) Provisions: § § 921 through 927

V. Other Issues

A. Corrective Distributions

B. Application of § 936 to Joint Ventures

C. Transfers of Intangibles Under § 936(h)(6)

D. Estimated Tax Liability for Intangible Property Inclusions

1. General

2. Uruguay Round Agreements Act Changes

a. Computing Annualized Installments for Intangible Property Inclusions

b. Safe Harbors

c. Effective Date

VI. Limitations on the § 936 Credit Imposed by the 1993 RRA

Introductory Material

A. Background

B. The Economic Activity Limitation

1. Qualified Possession Wages and Allocable Employee Fringe Benefit Expenses

2. Depreciation

3. Treatment of Possession Income Taxes

a. Non Profit Split Possession Corporations

b. Profit Split Possession Corporations

4. Consolidated Basis

a. Computation of Limitation

b. Election Procedures

C. The Percentage Limitation

D. Affiliated Groups

E. Choosing a Limitation

VII. Phaseout of § 936 Under the 1996 Act

Introductory Material

A. Details of the Phaseout

1. Economic Activity Limitation

2. Applicable Percentage Limitation

3. Computation of the Cap Amount

4. Existing Credit Claimant

5. Special Rule for Certain Possessions

B. Dealing with the Phaseout of § 936 Benefits

VIII. Sunset of § 936 and the Implications of Terminations; IRS Notice 2005-21

Introductory Material

A. Approach of Notice 2005-21

1. General Rules

2. Section 936 Corporation Continues its Activities as a Domestic Corporation

3. Section 936 Corporation Liquidates into its Domestic Parent Corporation

4. Section 936 Corporation Reincorporates as a Foreign Corporation

B. Effect of Termination of § 936 on Use and Transfer of Intangibles

C. Dividends from § 936 Corporation Earnings

D. Alternative Minimum Tax

E. Recapture of DCLs

F. Reporting Requirements

G. Subpart F Consequences

H. Implications of Termination

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Joint Committee on Taxation General Explanation (JCS-12-96) of Taxation Legislation Enacted in the 104th Congress (Dec. 18, 1996) pp. 207-213 (Small Business Job Protection Act of 1996)

Worksheet 2 House-Senate Conference Committee Report H.R. Rep. No. 103-213, 103rd Cong., 1st Sess. (Aug. 4, 1993) (To Accompany H.R. 2264) pp. 622-631 (Omnibus Budget Reconciliation Act of 1993)

Worksheet 3 Tax Reform Act of 1986 - Excerpt from Conference Committee Report to Accompany H.R. 3838

Worksheet 4 Tax Equity and Fiscal Responsibility Act of 1982 - Excerpt from General Explanation Prepared by the Staff of the Joint Committee on Taxation

Worksheet 5 Tax Reform Act of 1976 - Excerpt from General Explanation Prepared by the Staff of the Joint Committee on Taxation





Legislative History:

Revenue Procedures and Revenue Rulings: