Puerto Rico Tax Specialist Supports Possessions Credit Regs.

Louis P. Costas Elena of Santurce, Puerto Rico, has indicated his support for proposed regulations under section 936(h)(5), relating to the use of the profit-split method to allocate a possessions corporation's taxable income between the possessions corporation and its U.S. affiliate. Costas Elena says the regulations "should be supported as an effort to avoid complexity and the pitfalls discerned" in a study he submits with his comments. He urges "even greater strictness" in dealing with loopholes and abuses of section 936.

====== FULL TEXT ======

July 8, 1994

Internal Revenue Service

RE: Computation of Combined Taxable Income Under the Profit

Dear sirs:

Allow me to introduce myself: I am Luis P. Costas Elena, a practicing attorney in Puerto Rico, with both an L.L.M. degree and an S.J.D. degree from Harvard Lab School. I have taught taxation at the law schools of the University Of Puerto Rico and of Interamerican University. In 1977 I was Special Assistant to the Governor of Puerto Rico coordinating most of Puerto Rico's economic and financial public organizations, from the Puerto Rico Planning Board1 the Puerto Rico Treasury Department and Puerto Rico shipping and Telephone Companies to the Puerto Rico Economic Development Administration and Puerto Rico Governmental development bank. I have been Assistant Secretary in charge of Public Revenues of the Puerto Rico Treasury Department and thus the direct head of all impositive bureaux (income tax, property taxes, excises, inheritance and gifts, and alcoholic beverages). I have written extensively on the subject of section 936 and its antecedents -- "History of Federal Income Taxation in Puerto Rico; Analysis of the Possession Corporation in comparison with Other Nodes of Business operation in Puerto Rico: An Insight into Tax Exemption in Puerto Rico," my L.L.14. thesis, subsequently published in the Puerto Rico Bar Association Law Review, 36 Rev. C. de Abo. P.R. 477-582 (May 1975); "I.R.C. section 936 and Fomento Income Tax Exemptions in Puerto Rico," my S.J.D. thesis, which is the seminal article on the subject quoted in 48 USCA sec. 734, and is published in 40 Revista del colegio de Abogados de Puerto Rico 563-602 (November 1979) 41 Revista del Colegio de Abogados de P.R. 101-148 (February 1980); 41 Revista del Colegio de Abogados de P.R. 225-277 (May 1980), 42 Revista del Colegio de Abogados de P.R. 611-668 (November 1981).

The U.S. Treasury Department invited me to lecture its Office of International Tax Analysis before its issuance of its first study on the possession corporations, and I have repeatedly testified before the U.S. Senate Finance committee, the U.S. Senate Committee on Energy and Natural Resources, the House Ways and Means Committee, and the U.S. House Committee on Interior and Insular Affairs.

The Treasury Department's proposed income tax regulations for IRC section 936(h)(5), announced on Wednesday, January 12, 1994, for the purposes of simplifying the rules for computing combined taxable income under the profit split method for a taxpayer that has chosen a component product or an end-product as its possession product are needed and useful. All efforts to simplify and tighten the administration of the IRC section 926 loophole are to be encouraged.

The most recent reforms of IRC section 936 by the Omnibus Reconciliation Act of 1993 require simplified and effective administration in order to achieve the revenue gains for the United states Treasury and reduce or eliminate the endemic evils of IRC section 936. We must remember that this area of the law has a long history of abuse, even dating from its antecedent of IRC section 931.

The Omnibus Reconciliation Act of 1993 seeks to tighten and restrict IRC section 936, responding to widespread criticism of the huge federal revenue losses and abuses caused by section 936 corporations. E.g., D. Barlett & J. Steele, America: What Went wrong?, 95-96 (1992). See also the attached list of federal revenue losses in 1991 caused by various 936 companies.

The proposed income tax regulations should be supported as an effort to avoid complexity and the pitfalls discerned in the attached analysis -- International Institute for Advanced Studies, Puerto Rico and Section 936, Costly Dependence 40 (1993).

I do urge, however, that even greater strictness is needed in dealing with the loopholes and abuses of IRC section 936. Hopefully, at some future time, IRC section 936 will be eliminated. See D. Barlett & J. Steele, America: Who Really Pays The Taxes? 50-51, 80- 81, 212-247 (1994).

Sincerely,

Luis P. Costas Elena

TAX SAVINGS REPORTED BY SELECTED COMPANIES

COMPANY NAME                       $SAVED    %SAVED    FISCAL YEAR

BRISTOL-MYERS SQUIBB          $219,412,000     7.60%       1991

SOURCE: ANNUAL REPORTS

TRIBUNAL RUSSELL II SOBRE LA AMERICA LATINA

PRINCIPIOS Y DESARROLLO LEGISLATIVO DE

SEGUNDO CONGRESO INTERNACIONAL DE

ALEJANDRO RAMIREZ Y LA CRISIS DEL PAPEL MONEDA:

Lcdo. Luis E. Gonzalez Vales

EXPLOTACION MINERA:

Lcdo. German A. Gonzalez y Lcdo. Luis Sanchez Betances

HISTORY OF FEDERAL INCOME TAXATION IN PUERTO RICO;

Lcdo. Luis P. Costas Elena

SITUACION DEL MERCADO DE ALQUILERES EN PUERTO RICO

Lcdo. Tadeo Negron Medero

JURISPRUDENCIA

Lcdo. Luis Mojica Sandoz

EL COLEGIO DE ABOGADOS ANTE LA CRIMINALIDAD

REVISTA DEL COLEGIO DE ABOGADOS DE PUERTO RICO

ury Sol Luis Descartes, /377/ and thereafter the Treasury Department

His concern, however, as well as that of the other island officials who subsequently took a stand against profit-shifting, was not the revenue lost by the United States but Puerto Rico and its public relations image. /379/ Shifting United States profit to businesses tax exempt in Puerto Rico effectuated no additional revenues for the island Government. But such profit-shifting availed certain State representatives (who charged that island tax exemption programs took businesses away from the States, especially poor Southern States, and put States citizens out of work) of the chance to unite with federal officials who felt the revenues lost. And united these could definitely force Congress to amend one or more keystones of favoritism for Puerto Rico I.R.C. sec. 921, 931 or 933. /380/

Thus, on 22 July 1954 Mr. Descartes staked his policy against profit-shifting on one example that he submitted to the President of the Ad Hoc Committee on Tax Policy, Roberto Sanchez Vilella, for consideration by the Committee: Puerto Rico Precision Tools, Inc., the case of a Delaware corporation organized in 1952 to do business in Puerto Rico as a wholly-owned subsidiary of Remington Rand, Inc. From 1945 to 1954 all consolidated Remington Rand enterprises as a percentage of their sales had net income that fluctuated between 9.6% in 1954 to 18.22% in 1947. But this subsidiary, Puerto Rico Precision Tools, Inc., one year after its incorporation had 81% and the next year 76%, i.e., in 1953 from sales of $3,800,000 the subsidiary had net income of $3,070,000 and in 1954 from sales of $6,100,000 the net income of $4,632,000.

The exempt subsidiary received income, and the taxable parent kept deductible costs. In 1953 the subsidiary had a cost of goods sold to the total value of sales ratio of 16% and in 1954 of 20% while the domestic parent had respectively 53% and 56%. And although the consolidated Remington Rand enterprises from 1945 to 1954 as a percentage of their sales paid salaries, wages and commissions that fluctuated from 46.6% in 1945 to 56.07% in 1950, with 53% in both 1953 and 1954, the subsidiary for said item paid 2.83% in 1953 and 4.78% in 1954. As dollar amounts the total paid by the subsidiary in wages, salaries and commissions was respectively $107,500 and $289,500. /381/

On 29 July 1954 the Ad Hoc Committee on Tax Policy ascertained that the solution to profit-shifting was an official statement of its disapproval by the Governor of Puerto Rico.

The Minutes of the Meeting speak for themselves:

The problem of profit shifting which appears as Item No. 2 on the Governor's agenda, was selected as the first topic for discussion.

Mr. Descartes stated that in his preoccupation with the problem of profit shifting, he was not concerned with collecting taxes for the Federal Treasury, but rather with avoiding bad publicity for the tax incentive program. He would like to be able to show that the Government of Puerto Rico has taken steps to demonstrate its good faith in insuring that the tax incentive program is not used mainly as a haven for escaping the taxes of other jurisdictions.

Mr. Ramirez raised the question as to just how serious is the problem of profit shifting as matter of fact. Mr. Descartes replied that it was difficult to ascertain. In some cases the profits declared were so unusually high that they raised the question of the possibility of profit shifting. In this connection, he mentioned the high profits of Puerto Rico Precision Tool Company [sic].

Mr. Sirken remarked that the existence of possible high profits was not necessarily a symptom [sic] of profit shifting. Thus in the case of Puerto Rico Precision Tool Company there were special factors such as the fact that the product was protected by a patent, the plant was exclusively devoted to the manufacture of one product, and had been operated on a twenty-four [sic] basis. Mr. Sigafoos remarked that the PROFIT OF PRECISION TOOL COMPANY ACCOUNTED FOR APPROXIMATELY 25% OF THE TOTAL REMINGTON RAND PROFITS FOR THE PAST YEAR.

Mr. Sanchez Vilella observed that we must insure that people do not come to Puerto Rico under the tax incentive program for the sole or main purpose of evading the taxes of other jurisdictions. Mr. Descartes stated that the placing of conditions in the grants made under the new law, making it a violation of the grant to attribute the operations in Puerto Rico profits made and taxable elsewhere, was an excellent beginning but more remained to be done.

Mr. Rodriguez stated that the problem is doubtedly a real one, but the main problem is one of emphasis. Mr. Ramirez observed that the Federal Government has more ample facilities for ascertaining the possibility of profit shifting than the Commonwealth Government.

Mr. Sanchez Vilella stated that it was evident that all were in agreement that there is a problem and a recommendation could be made to that effect and to the effect that some steps should be taken to deal with it. For it was evident that if nothing at all were done about the problem the position of the Commonwealth in the face of unfriendly criticism of the program would be weak.

Mr. Rodriguez pointed out that we should all be conscious of the difficult technical problems involved, such as the proper allocation of costs. Mr. Sanchez Vilella recommended that a statement of policy should be adopted to the effect that the Government of the Commonwealth of Puerto Rico looked with disfavor on enterprises coming to Puerto Rico mainly for the purpose of evading the taxes of other jurisdictions.

Mr. Descartes suggested that the condition in the grant should be supplemented by further routine steps such as sending a copy of each grant to the Federal Bureau of Internal Revenue. Mr. Sanchez Vilella stated that he believed that it was unnecessary to take such a step of sending a copy of each grant to the Federal Bureau of Internal Revenue, and that contact with that agency should be restricted to those cases which appeared to be clearly established violations of the policy against profit shifting.

Mr. Ramirez suggested that a copy of any statement of policy adopted on profit shifting together with any pertinent section of the rules which are to be adopted, dealing with the subject of abuse of grant should be sent to each applicant.

Mr. Descartes stated that in order to enforce any policy on this subject we must secure certain basic economic information about the mainland companies related to the grantees. Mr. Ramirez observed that we have a difficult time in promoting people to come to Puerto Rico and the more data we ask for, the greater the difficulty. Mr. Descartes stated that if the necessary financial data could not be secured from the companies themselves, his department would have to rely on general data concerning each industry. Mr. Ramirez pointed out that there ware many firms in the States which made it a strict policy not to give out their balance sheets and profit and loss statements. These companies do not have to rely on any credit rating in order to secure credit. Mr. Sanchez Vilelia suggested the possibility of having a general rule requesting specified financial information with specific provision for discretion to waive it for good cause shown in particular cases.

Mr. Goldman pointed out that in connection with whatever information that may be asked for, we must have a rule providing for confidential treatment of such information. It was agreed that this should be a recommendation of the committee. /382/

Since at 16 March 1955 nothing had yet been done about profit- shifting, Mr. Descartes reminded Mr. Sanchez Vilella that Puerto Rico Precision Tools, Inc., merited consideration by the Committee. /383/ On 16 May 1955 the Committee studied the statistical data in this case but took no action because Mr. Moscoso stated that he had talked to the management of Precision Tools and that he believed the Committee "should await result of operations after they have engaged in the whole operation." /384/ The Treasury Department thereafter discovered that in 1955 Precision Tools divided itself into two corporations; one corporation had $3,100,000 total sales with $2,080,640.66 net income and the other had $2,500,000 total sales with $2,113,750.28 net income.

On 8 May 1956 Governor Luis Munoz Marin signed a memorandum that directed all the involved agencies to observe in the administration of the tax exemption laws the policy of Puerto Rico which disapproved of profit-shifting. The Memorandum also established a procedure whereby if the Treasury Department discovered a flagrant case of profit-shifting, the Department should refer the case to the Office of Tax Exemption, which then would provide the questioned business an opportunity to prove its nonindulgency in profit-shifting. If it disbelieved the questioned business, the Office should refer the case to the federal, Internal Revenue Service but not without the explicit prior consent of the Governor. /385/

As of 1956 the Internal Revenue Service became increasingly preoccupied with the profit-shifting to Puerto Rico and strengthened its island office with five more agents. Then, following instructions from the Governor, on 28 June, Secretary of the Treasury Rafael Pico visited the head of this federal office in Puerto Rico and promised him the full cooperation of the Government of Puerto Rico to stop the profit-shifting. As evidence of this full cooperation Mr. Pico gave the federal official a copy of the May Memorandum of the Governor. /386/ This federal agency, accordingly, in January 1957 proceeded to implement said cooperation and sent its agents to those insular agencies responsible for the tax exemption program of Puerto Rico. The Service hoped to establish in those agencies channels of information. /387/

But the pledge of full cooperation had very curious results. To the Ad Hoc Committee on Tax Policy this pledge signified as of 31 May 1957 the transmittal to the Service by Fomento of a list with the names of new tax exempt businesses that were subsidiaries of domestic parents. The Committee did not allow that this federal agency use island investigatory findings or that island agencies pinpoint to the Service probable examples of profit-shifting. Moreover, because the Service had entered the field, the understanding was that the Treasury Department should stop its investigations. As to Puerto Rico Precision Tools, Inc., the General Counsel or Fomento specifically asked of the Treasury representative that since the list was being submitted to the federal Service whether the meeting planned for the current week should be suspended of the Remington Rand officers with the Secretary of the Treasury and the Governor of Puerto Rico. /388/ By June 1957, in the quaint phrase of the General Counsel of Fomento, the Treasury' Department ceased "investing its valuable time and scarce technicians in further investigations on this problem"; and the case of Puerto Rico Precision Tools, Inc., ended. /389/

The Internal Revenue Service then commenced fulfilling its duty to investigate the profit-shifting, and by the first years of the 1960 decade this federal agency had in process many audits of businesses tax exempt in Puerto Rico. But, after the direct intervention of the Governor of Puerto Rico, the Internal Revenue Service issued orders in 1963 to suspend all the unfinished cases of profit-shifting to the island /390/ and because of the "peculiar political connection between Puerto Rico and the United States" with haste, faster than for the rest of the world, published Guidelines on I.R.C sec. 482 for Puerto Rico. /391/ The Revenue Service in the interim also settled or conceded with taxpayers more than half of those cases involving the taxable years 1963 to 1967. /392/

FOOTNOTES

/377/ Memorandum from Pablo J. Lopez Castro, Director Divisior of Exemptions Fiscalization, to Sol Luis Descartes, Secretary of the Treasury, May 28, 1954.

/378/ For the background of the officials here and after named in the text and their roles in the economic development of Puerto Rico see W. STEAD, FOMENTO -- THE ECONOMIC DEVELOPMENT OF PUERTO RICO (National Planning Ass'n. Pub. No, 103, 1958). Suffices to say that they are some of the most reknown Puerto Ricans and have held the most important positions in the Government of Puerto Rico, including the position of Governor.

/379/ Memorandum from Sol Luis Descartes, Secretary of the Treasury, to the Ad Hoc Committee or Tax Policy, July 28, 1954; Minutes to the Meeting of the Ad Hoc Committee or Tax Policy, July 29, 1954.

/380/ Cf. Baker, supra note 356, at 329, 332-333.

/381/ Memorandum from So Luis Descartes, Secretary of the Treasury, to Roberto Sanchez Vilella, President, Ad Hoc Committee on Tax Policy, July 22, 1954.

/382/ Minutes to the Meeting of the Ad Hoc Committee on Tax Policy, July 29, 1954 (emphasis added).

/383/ Letter from Sol Luis Descartes, Secretary of the Treasury, to Roberto Sanchez Vilela, President, Ad Hoc Committtee on Tax Policy, March 16, 1955.

/384/ Memorandum from Pablo J. Lopez Castro, Director Division of Exemptions Fiscalization, to Rafael Pico, Secretary of the Treasury, May 12, 1955, at 3.

/385/ Memorandum from Luis Munoz Marin, Governor of Puerto Rico, to the Secretaries of State, Justice, Treasury, Labor, Agriculture, and Health; the Administrator, Economic Development Administration; and the Director, office of Tax Exemption, May 8, 1956:

"In view of the delicate nature of the problem, involving as it does, our relations with other tax jurisdictions great care and discretion must be used in the application of the policy. Any measure proposed in specific cases, where other tax jurisdictions are involved, should be brought to my attention directly or through the Secretary of State, for approval, before referring a case outside the jurisdiction of the Commonwealth of Puerto Rico."

/386/ Letter from Rafael Pico, Secretary of the Treasury to David Rodriguez, Assistant to the Governor, June 28, 1956.

/387/ Memorandum from Teodoro Moscoso, Administrator, Economic Development Administration, to Rafael Pico, Secretary of the Treasury, and to Marco A. Rigau, Executive Assistant to the Governor, Jan. 23, 1957 (with accompanying memorandum for the record by Enrique Bird, Executive Assistant of the Administrator, Economic Development Administration, Jan. 22, 1957).

/388/ Memorandum frog Pablo J, Lopez Castro, Director, Division of Exemptions Fiscalization, via Juan Labadie Eurite, Auxiliary Secretary of the Administration of Financial Affairs, to Rafael Pico, Secretary of the Treasury, June 6, 1957 (Minutes to the Meeking of the Ad Hoc Committee on Tax Policy of May 31, 1957).

/389/ See Memorandum from Mariano H. Ramirez, General Counsel, Economic Development Administration. to Carlos M. Passalacqua, Acting Administrator, Economic Development Administration, May 31, 1957; Memorandum from Pablo J Lopez Castro. Director, Division of Exemptions Fiscalization, via Juan Labadie Eurite, Auxiliary Secretary of the Administration of Financial Affairs, to Rafael Pico, Secretary of the Treasury, June 1-3, 1957.

/390/ Dale, supra note 296. at 365-366.

/391/ Tillinghast, The Position of the Treasury Regarding Section 482 Adjustments and Relief Under Rev. Proc. 64-54, in INSTITUTE ON U.S. TAXATION OF FOREIGN INCOME, INC., supra note 365, at 6-7 (during 1962-1964 Special Assistant for International Tax Affairs, United States Treasury Department).

/392/ Dale, supra note 296, at 366.

END OF FOOTNOTES

[America: What went wrong? has been omitted.]

PUERTO RICO AND SECTION 936

A COSTLY DEPENDENCE

J. Tomas Hexner

Cambridge, Massachusetts

TABLE OF CONTENTS

I. INTRODUCTION

II. THE LEGISLATIVE HISTORY OF SECTION 936

Background

Combatting Transfer Pricing Abuses

Section 936 Eligibility and Links to Investment and Employment

III. THE MECHANICS OF SECTION 936 AND RELATED LEGISLATION

The Section 936 Tax Credit

Complementary Puerto Rican Tax Incentives

The TEFRA Amendments to Section 936

IV. THE ECONOMIC IMPACT OF SECTION 936 ON PUERTO RICO

The Broad Economic Trends

The Relationship between Section 936 and Transfer Pricing

V. SECTION 936 AND THE CARIBBEAN BASIN INITIATIVE

Targeting Section 936 at the Broader Goals of Regional

Evaluation of the CBI: A Weak Justification for Prolonging

VI. 1993 REFORMS AFFECTING SECTION 936

Section 482 Temporary Regulations on Transfer Pricing

Possible Effects of Section 482 Temporary Regulations on

Further Limitations on the Section 936 Tax Credit

VII. CONCLUSION

BIBLIOGRAPHY

I. INTRODUCTION

For over seventy years, American corporations have been granted tax incentives to operate in U.S. territorial possessions, most notably in Puerto Rico. /1/ The purpose, in so benefitting what have become known as possessions corporations," is to attract U.S. capital to these developing territories, with the goal of creating jobs. /2/

At the outset, this approach -- as expressed first in section 262 of the Revenue Act of 1921, and ultimately in section 936 of the Internal Revenue Code -- was successful. In Puerto Rico, during the 1950s and 1960s, it spurred the island's industrialization, infrastructure development, and the attendant growth in employment and GNP. By the mid-1970s, however, the job-creation benefits of section 936 took a backseat to the corporate tax schemes, which brought great financial gain to only a few U.S. companies, substantial cost to the U.S. Treasury, and a competitive disadvantage to "native" Puerto Rican enterprises.

This problem persists in large part because the use of section 936 can have an immense impact on profits: possessions corporations receive full credit against the U.S. taxes owed on the net income earned in a possession. Accordingly, companies are able to benefit by transferring income from intangible assets developed in the U.S. to their possessions-based operations. They then claim the tax credit on this income without making the corresponding real investments for which the credit was intended.

The attractiveness of section 936 as a tax scheme has come to far outweigh its role as an employment-producing incentive. The companies benefitting most from the credit have been capital- intensive firms such as pharmaceutical companies. Those benefitting least have been labor-intensive industries such as apparel manufacturers.

For example, in Puerto Rico, during the 1980s, the pharmaceutical industry received about 50 percent of the total tax benefits from section 936 while providing only 15-18 percent of the section 936 jobs. In 1989, the latest year for which aggregate data are available, this translated into the pharmaceutical industry receiving $1.2 billion of all section 936 credits, while employing only about 18,000 of the 106,000 workers in section 936 firms. The average cost to the U.S. Treasury for each Puerto Rican job in the pharmaceutical industry that year was $66,081, while the average compensation was $30,447. Thus, for each dollar of employee compensation, pharmaceuticals received $2.17 in tax benefits from the U.S. Treasury. /3/

The total cost of the section 936 tax credit to the U.S. Treasury in 1989 was approximately $2.5 billion. /4/ The present value of its cumulative cost during 1973-89 is approximately $52 billion. /5/ The Treasury Department's Office of Tax Analysis projected that the costs of section 936, were it not revised, would continue rising at some 10 percent annually, /6/ while the Congressional Budget Office calculated that the incentive scheme would bring losses of $15 billion in potential tax revenues during 1993-97. /7/

These conditions made section 936 a logical target for deficit- reduction legislation in President Clinton's budget. The revised section 936 provisions will restructure and reduce the tax credit effective December 31, 1993. In particular, Congress has legislated a connection between the tax credit and employment and investment growth in the possessions.

Although reform is desirable, this paper argues on an historical basis that section 936 should not merely be fixed, and indeed, that it CANNOT be fixed. Our contention is that section 936 has:

o essentially operated as a costly tax benefit to a few

o resulted, through links with the Caribbean Basin Initiative,

o created a tax-subsidy-oriented development strategy, which for

o has generated, understandably, a powerful lobbying effort to

We find further that the revisions to section 936, as provided in

Section II of this report reviews the historical background of section 936, and section III examines its mechanics and looks at the technical aspects of related legislation. In particular, we explore the relationship between section 936 and regulations issued to limit transfer pricing abuses. Section IV analyzes the impacts of Section 936 on Puerto Rico. Section V explores the legal relationship between section 936 and the Caribbean Basin Initiative -- an act that will prolong the tax incentive. Section VI outlines the elements of the most recent attempts to reform the tax credit. Section VII concludes that section 936 cannot and should not be fixed because, as a development strategy, it is expensive and ineffective -- expensive to U.S. taxpayers and ineffective in stimulating the growth of the Puerto Rican economy.

FOOTNOTES

/1/ These territorial possessions now include Puerto Rico, the U.S. Virgin Islands, the Commonwealth of the Northern Marianas, the Federated States of Micronesia, the Marshall Islands, American Samoa, and Guam. The Philippines was considered a U.S. possession until 1946, when it was given its independence.

/2/ A possessions corporation is the subsidiary of a U.S. corporation doing business in a U.S. territorial possession under the special tax credit afforded to such corporations.

/3/ J. Bradford, "U.S. Possessions Corporations Returns, 1989," U.S. Department of the Treasury, Office of Tax Analysis, p. 103.

/4/ Id.

/5/ U.S. Department of the Treasury, "The Operations and Effect of the Possessions Corporation System of Taxation, Sixth Report," 1989, Table 4-11. Figures for 1984 and 1986 were imputed by taking the mean between available data for 1985 and 1987. The discount rate used was 8 percent.

/6/ P. Morrison, "Testimony before the Committee on Finance, United States Senate," April 26, 1990, p. 2.

/7/ U.S. General Accounting Office, "Pharmaceutical Industry: Tax Benefits of Operating in Puerto Rico," Briefing Report to the Chairman, Special Committee on Aging, U.S. Senate, May 1992, p. 1.

/8/ See J.T. Hexner, G. Jenkins, H.F. Ladd, and K.R. LaMotte, Puerto Rican Statehood: A Precondition to Sound Economic Growth, November 1993. This report shows that section 936 acts as an unsustainable crutch in the Puerto Rican economy and, in so doing, creates significant market distortions, thereby impeding the economic development of the island.

END OF FOOTNOTES

II. THE LEGISLATIVE HISTORY OF SECTION 936

BACKGROUND

Since the Revenue Act of 1921 (with its section 262, the predecessor of section 936), the United States government has provided a tax incentive for U.S. corporations operating in its territorial possessions. /1/ The original goal was to help American corporations compete with foreign firms in the Philippines. /2/

Section 262 exempted qualified U.S. corporations from taxes on all income derived from sources outside the United States. To qualify, a corporation had to derive 80 percent or more of its gross income from its operations in U.S. possessions, and 50 percent or more of its gross income from active trade or business in the possessions. /3/ These gross income tests had to be met on an aggregate basis for the year of the exemption and for the two preceding tax years if the corporation had conducted a trade or business in a possession during that period.

Under the 1921 act, dividends paid by the possessions corporation to corporate shareholders were fully taxable. In the Revenue Act of 1935, however, this policy was abandoned. Moreover amounts received upon liquidation were made tax-exempt. /4/

In 1948, by coupling these U.S. tax incentives with various local tax incentives, Puerto Rico initiated a more aggressive program to attract major capital investment. This program, gown as "Operation Bootstrap." /5/ attracted a surge of U.S. corporations, particularly in labor-intensive industries. From 1948 to 1972, Puerto Rico's real gross national product (GNP) grew at an average annual rate of 6 percent (compared to a rate of 3.7 percent for the United States). /6/ At the same time, the island's economy shifted from its traditional agricultural base to manufacturing, where employment increased from 55,000 in 1950 to 142,000 in 1972. /7/ Indeed, the program was so successful that during the l950s and 1960s Puerto Rico was dubbed the "economic miracle" of the Caribbean. /8/

After this boom, however, the Puerto Rican economy stagnated. And while the section 936 lobby has attempted to maintain and disseminate the historical boom illusion, the annual rate of physical investment declined by nearly 30 percent between 1973 and 1978, from $1.5 billion to $1.1 billion. /9/ In the next five years, from 1978 to 1983, new physical investment fell another 35 percent, from $1.1 billion to $0.7 billion. /10/ Private investment in plant and equipment also fell steadily from 10.3 percent of GNP in 1973 to 4.6 percent in 1983. /11/

By the mid-1970s, the possessions tax benefit began to be criticized as an insufficient stimulus for employment-producing investments in Puerto Rico and the other possessions. Later, during the 1980s, other criticism emerged to the effect that, because the tax incentive provided that liquidation receipts were tax-exempt, possessions corporations were accumulating and investing earnings in the Eurodollar market and other foreign markets for long periods before liquidating and repatriating these earnings tax-free to the United States. /12/ By the mid-1980s, opponents of the tax benefit further argued that its cost in foregone tax revenue contradicted deficit reduction efforts by the U.S. Treasury. /13/

Those favoring a continuation of the tax exemption countered that the incentives were needed to offset the costs of federally imposed requirements in the possessions. U.S. law, for example, set minimum wages and mandated the use of U.S. flag vessels to transport goods to the mainland. This was said to disadvantage Puerto Rico, and other U.S. possessions generally, in competition with other developing countries for U.S. investment. /14/

Congress responded to the early criticisms by creating a new section 936 of the Internal Revenue Code in the Tax Reform Act of 1976. /15/ Congress stated that it sought to

. . . assist the U.S. possessions in obtaining employment-

The essence of the 1976 legislation has remained intact and will continue to apply until December 31, 1993. Its unsatisfactory performance, with respect to the goals of Congress, is, however, broadly apparent. The benefit to much-needed employment in Puerto Rico continues to be low (the unemployment rate in Puerto Rico is now 18.1 percent) relative to its mounting cost ($2.5 billion in 1989) to the U.S. Treasury. This result has occurred because the legislation supported (and continues to support, until December 31, 1993) possessions corporations and their affiliates in the exploitation of transfer pricing.

COMBATTING TRANSFER PRICING ABUSES

Before 1982, there were no explicit statutory guidelines on transfer pricing. /17/ This statutory silence provided possessions corporations with tacit permission to minimize their tax liability by shifting the taxable income attributable to property transferred from U.S. affiliates. A U.S. pharmaceutical company, for example, might develop a patentable drug in its U.S. laboratory and receive deductions on its U.S. federal income tax obligations for the research and development costs it incurred. The company would then transfer the patent to its wholly owned possessions corporation, which would produce the patented drug and would claim the resulting income as possession-source income. As a result, the company would owe little or no income tax, either in the United States or in Puerto Rico, for producing this drug. /18/

Congress and the Treasury have repeatedly reacted to this problem but have met with limited success. Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which added a new section 936(h) to the Internal Revenue Code to ensure that a sufficient percentage of income generated by such transferred intangibles would be allocated to the U.S. parent. /19/ Section 936(h) was revised again in 1986 to coordinate with section 482 provisions, which address transfer pricing in general. And, as recently as January 1993, Congress once again revised the regulations when it issued new temporary section 482 regulations, which refer to section 936(h).

SECTION 936 ELIGIBILITY AND LINKS TO INVESTMENT AND EMPLOYMENT

Congress has undergone a parallel effort to tighten the eligibility requirements for the tax exemption. It has repeatedly revised the gross income test (the minimum percentage of a section 936 firm's income that must be earned from the active conduct of trade or business in the possessions to qualify for the tax credit). Revisions to section 936 in 1976 set the minimum at 50 percent -- the same figure required under the antecedent legislation. The 1982 revision increased the minimum to 65 percent, and in 1986 it was raised again to 75 percent. /20/ Hence, a section 936 firm may now derive no more than 25 percent of its gross income from passive investments.

Stipulations in the Clinton Administration budget adopted in 1993 represent the most recent attempt to make section 936 "work." These provisions, which come into effect on December 31, 1993, aim to reduce the tax credit while strengthening its link to investment, employment, and wage growth in the possessions.

The following sections evaluate the specifics of the evolving section 936 legislation and related provisions.

FOOTNOTES

/1/ Revenue Act of 1921, Ch. 136, Sec. 262, 42 Stat. 227, 314.

/2/ The vast majority of section 936 companies conduct business in Puerto Rico. In 1987, nearly 97 percent of all U.S. possessions corporations operated in Puerto Rico and over 99 percent of the total section 936 credit was claimed by companies with operations in Puerto Rico. See J. Bradford, "U.S. Possessions Corporations Returns," p. 51. Consequently, this report will focus on the operation of section 936 in Puerto Rico.

/3/ U.S. Department of the Treasury, "Sixth Report," p. 5.

/4/ Revenue Act of 1935, Ch. 829, Sec. 112(b)(6), 49 Stat. 1014, 1020.

/5/ The Operation Bootstrap program was conceived by Puerto Rican Governor Luis Munoz Marin and promised U.S. corporations "cheap labor, exemptions from island taxes for up to 25 years (along with total exemption from U.S. Federal corporate and private income taxes), and assistance in the building of plants." Tansill, "Puerto Rico: Independence or Statehood?" Revista del Colegio de Abogados de Puerto Rico 41 (1980): 93.

/6/ U.S. Department of the Treasury, "Sixth Report," pp. 17, 19.

/7/ Id., p. 17.

/8/ Id.

/9/ Id., p. 24.

/10/ Id.

/11/ Id, p. 17.

/12/ Id., p. 7.

/13/ Id., p. 6.

/14/ Id.

/15/ See generally U.S. House of Representatives, "Report of the Committee on Ways and Means, U.S. House of Representatives, on H.R. 10612," Report No. 94-658, November 12, 1975; and U.S. Senate, "Report of the Committee on Finance, United States Senate, on H.R. 10612," Report No. 94-938, June 10, 1976.

/16/ U.S. House of Representatives, "Report on H.R. 10612," p. 255; and U.S. Senate, "Report on H.R. 10612," p. 279.

/17/ U.S. Department of the Treasury, "Sixth Report," p. 8. U.S. corporations operating in the possessions usually show profits in two ways. First, they earn profits from real investment in plant and equipment in Puerto Rico. Second, they are sometimes able to increase the amount of accounting profits reported in the possessions without any new physical investment by allocating to a possessions corporation income from intangibles (such as patents, trademarks, and trade names) that had typically been developed and paid for by an affiliated U.S. corporation and subsequently were transferred to the possessions corporation at a transfer price that does not reflect the market cost or the costs of development.

/18/ Id.; see also U.S. General Accounting Office, "Pharmaceutical Industry," p. 2. The U.S. Treasury took the opposite position, however, and argued that income obtained from drug sales in these transactions should be allocated to the U.S. parent and was subject to federal taxation. This issue resulted in lengthy litigation. See, for example, Eli Lilly and Co. v. Comm'r., 84 T.C. 996 (1985) and G.D. Searle & Co. v. Comm'r., 88 T.C. 252 (1987).

/19/ U.S. Department of the Treasury, "Sixth Report," p. 8.

/20/ The 1986 act also expanded the range of TYPES of investment income that qualify for the tax exemption. Income from deposits in Puerto Rican financial institutions that are used to finance development projects in Caribbean Basin Initiative countries now qualify.

END OF FOOTNOTES

III. THE MECHANICS OF SECTION 936

THE SECTION 936 TAX CREDIT

Section 936 grants to subsidiaries of U.S. corporations operating in the possessions a tax credit /1/ equal to the U.S. federal income tax liability from such operations. /2/ This credit is based on the taxable income derived from: (a) trade or business within the possession, /3/ (b) the sale or exchange of substantially all of the assets used by the subsidiary in this trade or business, /4/ and (c) "qualified possession source investment income, (QPSII)" (i.e., passive income resulting from investment, in the possessions, of the exempted profits). /5/

The credit is available to any U.S. corporation that during the three years prior to the close of the tax year (or for such part of such period immediately preceding the close of the tax year as may be applicable) earned 80 percent or more of its gross income from possession sources, /6/ and earned 75 percent or more of its gross income from the active conduct of trade or business within the possessions. /7/

U.S. parent corporations are eligible for a dividends-received deduction on dividends received from a possessions corporation. /8/ If the possessions corporation is a wholly owned subsidiary -- as most of them are -- the deduction equals 100 percent of the dividend. /9/ Such a possessions corporation can therefore repatriate to its U.S. parent, free of any U.S. federal income tax liability, its income earned in the possessions. Possessions governments may, however, impose their own taxes on earnings of the possessions corporations. This can include, as is the case for Puerto Rico, a tollgate tax on the repatriated earnings. /10/

Gross income received on the mainland by a possessions corporation is only considered possession-source income if it is derived from trade or business with unaffiliated parties. /11/ If a U.S. corporation deposits payments into a bank account on the mainland of a possessions corporation subsidiary as payment for goods manufactured by that subsidiary in Puerto Rico, the payment will not be considered possession-source income of the subsidiary. /12/ The subsidiary must receive payment in Puerto Rico for goods and services for that payment to be considered possession-source income that qualifies for the section 936 tax credit. /13/

A possessions corporation may not join in a consolidated return with its parent or any affiliated corporations, even in a year in which it fails to satisfy either the 80-percent possessions-source test or the 75-percent active trade or business test. /14/ Hence, operating losses incurred by a possessions corporation may not offset the taxable income of the parent or an affiliated corporation. This means that a subsidiary engaged in trade or business in a possession ordinarily will not elect to file under section 936 until it is no longer incurring start-up losses. /15/

The section 936 tax credit is not available for use against the environmental tax, /16/ the tax on accumulated earnings, /17/ the personal holding company tax, /18/ or taxes arising out of recoveries of foreign expropriation losses. /19/ For purposes of the accumulated earnings tax, the accumulated taxable income of a possessions corporation does not include taxable income eligible for the section 936 credit. /20/ The credit is also unavailable to a corporation for any tax year in which that corporation is a Domestic Sales International Corporation (DSIC) or former DSIC, /21/ or for any tax year in which it owns stock in a DSIC or former DSIC, /22/ or in a Foreign Sales Corporation (FSC) or former FSC. /23/

A possessions corporation may elect to use section 936 by filing Treasury form 5712. For the first tax year in which a possessions corporation applies for the section 936 credit, the form must be submitted on or before the date on which the federal income tax return is filed. /24/ An election to use the credit may not be revoked for a period of ten years without consent from the Secretary of the Treasury. /25/

COMPLEMENTARY PUERTO RICAN TAX INCENTIVES

In addition to the tax credit provided under section 936, the Puerto Rican government has, since 1948, provided its own complementary tax incentives for manufacturing and other specified business activities. Puerto Rico currently grants partial exemptions (of 90 percent) from income tax and other taxes to approved businesses for specified periods of time, usually from 10 to 25 years. /26/ A business is generally eligible for an exemption if it is producing on a commercial scale in Puerto Rico a "designated service unit" /27/ or a manufactured product not produced in Puerto Rico before January 1, 1947. /28/

Companies that meet that criterion are entitled to a 90-percent income tax exemption, for a period that varies according to the level of business activity in the area where the business is located: /29/

     LOCATION                          DURATION OF EXEMPTION

     High Development Zone                   10 years

Qualified manufacturers also receive partial exemptions (up to 90 percent) on property taxes on the personal or real property that generates the exempted income. Moreover, a manufacturing company with gross income of less than $500,000 in any year and with average employment that year of at least 15 persons receives a 100-percent deduction of its first $100,000 of income. A 60-percent exemption from municipal license (gross receipts) taxes is also granted. Businesses that qualify for these exemptions are subject to a special surcharge equal to the lesser of 0.075 percent of sales or 0.5 percent of net income if their income is in excess of $100,000 in a tax year. /30/

A tollgate tax of up to ten percent may be imposed on earnings repatriated to the United States or to a foreign country. The rate depends on the amount and the length of time that these earnings were invested in Puerto Rico prior to their repatriation. Holding earnings in certain designated investments in Puerto Rico (such as Puerto Rican bonds, bank savings certificates, participation in construction loans, or investment in the company's own additional plant and equipment) for five or more years will decrease the tollgate tax rate by one percent for each year that the investment is maintained. Thus, earnings invested in these instruments for six years will result in a four-percent tollgate tax rate when the earnings are repatriated. If the amount invested is at least 50 percent of the income of the exempted business for a given year, then all of that year's earnings will qualify for the reduced tollgate tax rate. The fifty percent (or less) of net income not invested can be repatriated immediately at the reduced rate. At the end of the investment period, the invested funds can also be repatriated at the reduced rate. /31/

The following hypothetical example illustrates how these rules operate: /32/

Example No. 1

                                    MANUFACTURING PLANT LOCATION

Sales                               $150,000,000    $150,000,000

                         FOOTNOTES TO TABLE

     /a/ The 10-percent tollgate tax applied assumes immediate

     /b// Tax savings is the difference in potential income tax

                      END OF FOOTNOTES TO TABLE

Ninety percent of the income of this pharmaceutical subsidiary would be exempt from local income taxes. The remaining ten percent would be taxed at a rate of 45 percent. Also, the 0.075 percent surtax on sales and the tollgate tax on repatriated earnings apply. Consequently, the tax would be $2,250,000 (10 percent of the $50,000,000 in income taxed at a rate of 45 percent) less $21,250. /33/

This amounts to a total of $7.11 million owed to the government of Puerto Rico on income of $50 million, compared to an estimated $17.5 million that would be owed on similar income derived from mainland operations. The effective tax rate for this company is thus only 14.22 percent (the sum of $7.11 million in income tax, surtax, and tollgate tax divided by $50 million in income), compared to the 35-percent maximum corporate tax rate the corporation would face on similar operations in the U.S. As this example shows, a U.S. company that operates in Puerto Rico under section 936 stands to reap a substantial increase in net after-tax profits through the drastic reduction in tax liability available on the island.

THE TEFRA AMENDMENTS TO SECTION 936

Since 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) has provided statutory rules for the allocation to a possessions corporation of income from intangibles that were developed or purchased by its affiliated corporations. The act is one in a series of attempts by Congress to stem transfer pricing abuse.

TEFRA added a new section 936(h) to the Internal Revenue Code. This section provides that income from intangible property, which is not owned by a possessions corporation, is not eligible for the section 936 tax credit. Rather, it is generally taxable to the U.S. shareholders of the possessions corporation. TEFRA provides further that a possessions corporation and its affiliates may elect out of this general rule under either a "cost sharing" option or a "50/50 profit-split" option. /34/

These two options provide methods by which a possessions corporation may claim an appropriate portion of the income from intangible property that is transferred from its affiliates. If the possessions corporation does not elect either method, it must compute its income from intangible property based on a reasonable profit on the costs that are attributable to such income. /35/

The cost sharing and profit-split options apply only to "possession products" products produced wholly or partially by a possessions corporation. /36/ The possessions corporation must elect to treat all products in the same product area (defined by reference to three-digit classification using the Standard Industrial Classification code (SIC)) in a like manner. /37/ If a corporation elects one of these options, it may, however, make a different election for export and domestic sales. /38/

To be eligible to use either the cost sharing or profit-split option, a possessions corporation must have a "significant business presence" with respect to a particular product in a possession. This requires meeting one of two requirements:

25% VALUE-ADDED TEST

The possessions corporation must show that it incurred

65% LABOR TEST

Alternatively, the possessions corporation must show that it

Start-up operations of new 936 corporations and new possession

                     YEAR 1         YEAR 2         YEAR 3

Value-Added Test      10%             15%            20%

If, for any product, the possessions corporation elects the profit-split method, it must also have manufactured that product in the possessions. In the case of Puerto Rico, this requirement is met if: (a) the product has been substantially transformed by the possessions corporation in Puerto Rico; (b) the operations conducted by the possessions corporation in connection with the product are substantial in nature and generally are considered to constitute manufacture or production; or (c) the conversion costs incurred by the possessions corporation in Puerto Rico (including direct labor, factory burden, and testing of components) account for twenty percent or more of the total cost of goods sold by the possessions corporation. In this context, packaging, labeling, and minor assembly operations are not deemed to constitute the manufacture or production of product. /43/

THE COST SHARING OPTION

Under the cost sharing option, a possessions corporation is required to make a payment to its U.S. parent for 110 percent of its share of the cost (if any) of product area research that is paid or accrued by the affiliated group during the tax year. /44/ "Product area research" costs include research, development, and experimental costs, losses, expenses, and other related deductions, including amounts paid for the use of, or right to use, a patent, invention, formula, process, design, pattern, or know-how (or the amount paid for the acquisition of any of these), which are allocable to the same product area as that in which the possessions corporation conducts its activities. Also included is a pro rata portion of any costs, expenses, and other deductions that cannot definitely be allocated to a particular product area. /45/

The payment required of the possessions corporation is therefore 110 percent of a portion of the year's research expenditures of the affiliated group in the product area in which the possession product falls. /46/ This portion is defined as the ratio of (a) third-party sales of the possession product made by the affiliated group to (b) third-party sales of all products in the product area made by the affiliated group. /47/ The cost sharing payment is determined separately for each product by using the following formula:

Sales to Unrelated Persons

A possessions corporation may credit its payments under cost sharing arrangements with unrelated persons against its share of the cost of product area research paid or accrued by the affiliated group. On the other hand, amounts paid to, or on behalf of, related persons and amounts paid under any sharing agreements with related persons may not be credited against the possessions corporation's cost sharing payment for the tax year. /48/

Accordingly, a possessions corporation electing the cost sharing payment method is treated as the owner of the manufacturing intangibles (but not marketing intangibles) associated with the possession product. /49/

By virtue of a 1986 amendment to section 936(h)(5), the payment made under any cost sharing option cannot be less than what would be required under section 367(d) or section 482 of the Internal Revenue Code if the electing corporation were a foreign corporation. /50/ Section 367(d) and section 482 provisions essentially authorize the IRS to reallocate gross income and deductions between affiliated businesses. Such a reallocation is performed when the IRS, following specific guidelines, questions transfer prices and determines that a reallocation is required to stem tax evasion or to reflect income clearly.

The following are two examples for determining the amount of the cost sharing payment. They are based on examples given by the Treasury Department: /51/

EXAMPLE NO. 2

XYZ is a possessions corporation engaged in the manufacture and sale of four products (A, B, C and D), all of which are classified under the same three-digit SIC code. XYZ sells its production to a U.S. affiliate, P, which resells it to unrelated parties in the United States. P's third-party sales of each of these products produced in whole or in part by XYZ are $2,000,000 per product, or a total of $8,000,000 for A, B, C and D. P's other sales of products in the same SIC code are $8,000,000. The worldwide product area research of the affiliated group is $500,000. XYZ must compute its cost sharing amount for each individual product A, B, C and D as follows:

Sales to Unrelated Persons

     $2,000.000               x      $550,000      =      $68,750

The amount of the cost sharing payment would thus be $68,750. If, however, XYZ also received $10,000 in royalty income from an unrelated person for the licensing of certain manufacturing intangible property rights, the amount of the product area research ($500,000) would be reduced by that amount, to $490,000.

EXAMPLE NO. 3

The facts are the same as Example No. 2 except XYZ manufactures product D under a license from an unrelated person. XYZ pays the unrelated party an annual license fee of $25,000. Consequently, the worldwide product area research amount increases to $525,000.

Since a possessions corporation may credit its cost sharing payments to unrelated persons against its share of the cost of product area research paid or accrued by the affiliated group, an adjustment to the calculation made in Example No. 2 would have to be made as follows:

[($2,000,000/$16,000,000) x $577,500] - $25,000 = $47,187.50

Thus, a payment by the possessions corporation to an unrelated party under a cost sharing arrangement will serve to reduce the cost sharing payment, in this case by 31.36 percent. /52/

THE 50/50 PROFIT-SPLIT METHOD

Under the profit-split option, 50 percent of the combined taxable income of the possessions corporation and its U.S. affiliates, as derived from "covered sales" of the possession product, is allocated to the possessions corporation. /53/ The remainder of the combined taxable income is generally allocated to U.S. affiliates. For purposes of computing the combined taxable income from the possession product, all direct and indirect expenses relating to the product are taken into account, including income attributable to both manufacturing and marketing intangibles associated with the product. The combined taxable income is computed separately for each product produced, or type of service rendered, by the possessions corporation in the possession. The following provides an example for determining the combined taxable income under the profit-split method. It is based on a Treasury Department example: /54/

EXAMPLE NO. 4

XYZ, a possessions corporation, manufactures 200 units of possession product S. XYZ sells 100 units of S to an unrelated person in an arm's length transaction for $10 per unit. XYZ sells the remaining 100 units to its U.S. affiliate, A, which leases the 100 units to unrelated persons. The combined taxable income for the 200 units of S is determined as follows:

SALES

     1. Total sales by XYZ to unrelated persons (100 x $10)    $1000

TOTAL COSTS

     4. Total expenses /a/                                     $1200

COMBINED TAXABLE INCOME AND ALLOCATION OF INCOME

     5. Combined taxable income (line 3 minus line 4)          $ 800

                          FOOTNOTE TO TABLE

     /a/ Research, development, and experimental costs are the higher

                           END OF FOOTNOTE

Thus, the combined taxable income in this example ($800) is the total gross receipts from the possession product ($2,000) minus the total expenses attributable to the development and production of this product ($1200).

FOOTNOTES

/1/ The dollar amount of the section 936 credit is determined as follows:

Taxable Business and Investment Income

See R.J. Boles, "Tax Incentives for Doing Business in Puerto Rico,"

/2/ Internal Revenue Code Sec. 936(a)(1) (1989).

/3/ I.R.C. Sec. 936(a)(1)(A)(i).

/4/ I.R.C. Sec. 936(a)(1)(A)(ii).

/5/ I.R.C. Sec. 936(a)(1)(B). The operation of the qualified possession source investment income provision of section 936 will be discussed in Section V.

/6/ I.R.C. Sec. 936(a)(2)(A).

/7/ I.R.C. Sec. 936(a)(2)(B).

/8/ I.R.C. Sec. 243(b)(1)(C).

/9/ U.S. Department of the Treasury, "Sixth Report," p. 7.

/10/ Puerto Rican tax laws applicable to U.S. possessions corporations are discussed in the next part of this Section.

/11/ I.R.C. Sec. 936(b).

/12/ Pacific Basin Mfg. & Trade Co. v. Comm'r., 716 F.2d 638 (9th Cir. 1983); Rev. Rul. 79-168, 1979-2 C.B. 283.

/13/ Nevertheless, the standard foreign tax credit may be claimed for foreign taxes paid or accrued on income that does not qualify for the section 936 credit. See U.S. Department of the Treasury, "Sixth Report," p. 7.

/14/ R.J. Boles, "Tax Incentives," p. 125.

/15/ To the extent that any losses prior to electing section 936 status have been used beneficially to offset the U.S.-source income of an affiliated group, the possessions corporation will ultimately be required to "re-capture" such losses by treating them as U.S.- source income under the overall foreign loss recapture rules of I.R.C. Sec. 904(f).

/16/ I.R.C. Sec. 936(a)(3)(A); I.R.C. Sec. 59A.

/17/ I.R.C. Sec. 936(a)(3)(B); I.R.C. Sec. 531.

/18/ I.R.C. Sec. 936(a)(3)(C); I.R.C. Sec. 541.

/19/ I.R.C. Sec. 936(a)(3)(D); I.R.C. Sec. 1351.

/20/ I.R.C. Sec. 936(g).

/21/ I.R.C. Sec. 936(f)(1).

/22/ I.R.C. Sec. 936(f)(2)(A).

/23/ I.R.C. Sec. 936(f)(2)(B).

/24/ I.R.C. Sec. 936(e)(1); R.J. Boles, "Tax Incentives," p. 123.

/25/ I.R.C. Sec. 936(e)(2).

/26/ Puerto Rico Tax Incentives Act, Sec. 3, 13 L.P.R.A. Sec. 256b(a) (Supp. 1988) (approved Jan. 24, 1987).

/27/ 13 L.P.R.A. Sec. 255a(d)(4). The term "designated service unit" applies to certain service production activities such as distribution, investment banking, public relations, publicity, consulting, and computer services.

/28/ 13 L.P.R.A. Sec. 256a(d)(1).

/29/ See 13 L.P.R.A. Sec. 256(b)(d).

/30/ 13 L.P.R.A. Sec. 256b(a).

/31/ 13 L.P.R.A. Sec. 256c(b).

/32/ Based on examples given by the U.S. Department of the Treasury, Internal Revenue Service, in C.F.R.

/33/ See R.J. Boles, "Tax Incentives," Appendix B, p. 142, which explains the basis for this calculation.

/34/ I.R.C. Sec. 936(h)(5).

/35/ R.J. Boles, "Tax Incentives," p. 129.

/36/ The regulations under section 936(h) provide a flexible definition of the term "possession product." The term includes any item of property that is the result of a production process, including components and so-called "end-product forms." End-product forms are products that are treated as not including certain of their components for purposes of the business presence test (discussed infra) and the computation of income from the possession product.

/37/ I.R.C. Sec. 936(h)(5)(C).

/38/ I.R.C. Sec. 936(h)(5).

/39/ For purposes of the value-added test, the term "production costs" has the same meaning as in 26 C.F.R. Sec 1.471-11(b) except that the term does not include direct material costs and interest. Thus, production costs include direct labor costs and fixed and variable indirect production costs (other than interest). Fixed indirect production costs may include, among other costs, rent and property taxes on buildings and machinery incident to and necessary for manufacturing operations and processes. Variable indirect production costs may include, among other costs, indirect materials, factory janitorial supplies, and utilities. See 26 C.F.R. Sec. 1.471- 11(b).

/40/ I.R.C. Sec. 936(h)(5)(B).

/41/ Direct labor costs include the cost of labor that can be identified or associated with particular units or groups of units of a specific product. The elements of direct labor include such items as basic compensation, overtime pay, vacation and holiday pay, sick leave pay, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan paid or incurred on behalf of employees engaged in direct labor. I.R.C. Sec. 936(h)(5)(B).

/42/ I.R.C. Sec. 936(h)(5)(B).

/43/ R.J. Boles, "Tax Incentives," p. 130.

/44/ I.R.C. Sec. 936(h)(5)(C)(i)(I).

/45/ Section 482 of the code is to be applied if no intangible property is related to a product produced in whole or in part by a possessions corporation (discussed in Section VI).

/46/ I.R.C. Sec. 936(h)(5)(C).

/47/ U.S. Department of the Treasury, "Sixth Report," p. 10.

/48/ Treas. Reg. Sec. 1.936-6.

/49/ Section 936(h) distinguishes between these forms of intangible property. "Manufacturing intangibles" refers to any patent, invention, formula, process, design, or know-how. "Marketing intangibles" include any intangible property defined in section 936(h)(3)(B), if it is used in marketing a product. Therefore, a determination must be made under the cost sharing option as to what portion of the final sales price of the possession product constitutes a return to manufacturing intangibles (and is therefore tax-exempt income to the possessions corporation) and what portion is a return to marketing intangibles (and is therefore taxable income to the affiliates that perform the marketing). Regulations under section 482 of the Internal Revenue Code are applied to make this determination.

/50/ I.R.C. Sec. 936(h)(5).

/51/ Treas. Reg. Sec. 1.936-6.

/52/ In neither example may the payment be less than the payment that would be required under section 367(d) or section 482 of the Internal Revenue Code if the electing corporation were a foreign corporation.

/53/ "Covered sales" are sales by members of the affiliated group (other than foreign affiliates) to foreign affiliates or to unrelated persons. See Treas. Reg. Sec. 1.936-6.

/54/ Treas. Reg. Sec. 1.936.

END OF FOOTNOTES

IV. THE ECONOMIC IMPACT OF SECTION 936 ON PUERTO RICO

THE BROAD ECONOMIC TRENDS

The special tax credit afforded to U.S. corporations operating in the

Since the mid-1970s, however, the section 936 tax incentives have proved to be both ineffective and inefficient as a vehicle for sustained economic growth. Consistent with this conclusion are three telling concerns. First, both employment and new physical investment in Puerto Rico have stagnated. Second, the composition of section 936 production has declined in labor intensity and has become increasingly capital intensive. Third, the total cost of the tax credit to the U.S. Treasury has increased substantially. Collectively, these trends indicate that the limited benefit of the incentive to the Puerto Rican employee is increasingly unjustifiable in relation to the tax revenues foregone by the deficit-plagued U.S. Treasury.

Manufacturing employment in Puerto Rico virtually stagnated during 1970-86, and total nongovernment employment remained steady or declined throughout 1974-83. /2/ The island is currently experiencing very high unemployment (18.1 percent), low labor-force participation (45.7 percent), and a high rate of migration to the mainland in search of jobs. /3/ Similarly, during the past two decades, aggregate physical investment in Puerto Rico has remained stagnant. The annual rate of investment declined sharply during the 1970s and early 1980s, and total fixed annual investment is only now approaching the levels of the early 1970s. /4/

The change in the composition of section 936 corporations parallels this trend and is equally dramatic. Specifically, the share of section 936 activity during the past three decades in such labor- intensive industries as textiles has diminished significantly, while the share in capital- and technology-intensive industries such as pharmaceuticals, has increased commensurately. In 1960, for example, chemicals and machinery, two very technology-intensive industries, made up 22 percent of the net manufacturing income in Puerto Rico; by 1989 that share had increased to over 73 percent. /5/ Clearly capital-intensive firms -- rather than the labor-intensive industries that it was designed to attract -- have made the most use of the section 936 provision.

The part of the section 936 tax incentive that goes toward wages could be the most meaningful contribution of external capital to the economic health of Puerto Rico. With the high level of capital intensity, the ratio of wages and salaries to the total value added of section 936 firms is low. One indicator of this is the ratio of proprietors' income (profits, interest, etc.) to total value added for section 936 firms. In 1991 this figure was 92.3 percent for the pharmaceutical industry and 81.2 percent for the electrical machinery industry. These two industries collectively account for over 60 percent of the entire section 936 credit. Therefore, for those corporations that benefit from the majority of the incentive, wages and salaries accounted for less than 20 percent of the total value added.

In light of stagnant employment and investment on the island and the declining labor intensity of section 936 industries, the concern is therefore the increasing cost ineffectiveness of section 936. In 1989 the average revenue cost of the tax credit per employee in a section 936 corporation was $22,375. Before tax annual wages for the year were, however, only $20,540. Hence, the federal government paid approximately $1.08 for each dollar paid to employees of section 936 corporations. Section 936 is also ineffective with respect to its low impact on physical investment, as measured by total assets of section 936 corporations per dollar of foregone tax revenues. In 1989, the total assets of section 936 manufacturing firms amounted to $5.9 billion. Given the $2.5 billion tax revenue cost of the program in that year, it would take less than 2.5 years for the value of foregone tax resources to equal net assets. Put simply, raw cost effectiveness would have supported buying the section 936 manufacturing plant and equipment and literally giving it away to the corporations to operate, rather than prolonging the tax credit.

The problems with section 936 are most evident in the pharmaceutical industry. For the period 1980-90, the amount of estimated income exempt from taxes for 26 pharmaceutical firms examined by the GAO totalled about $24.7 billion. /6/ This translates into an estimated total tax savings of about $10.1 billion in 1990 dollars for the Puerto Rican operations of these firms. /7/ In 1989, however, the total assets of the pharmaceutical industry in Puerto Rico were only $2.53 billion. Perhaps the strongest indicator of the profitability of the Puerto Rican operations of these pharmaceutical firms is that 17 of the 21 most-prescribed drugs in the U.S. were authorized for manufacture in Puerto Rico. /8/ One senator has stated that the GAO document "undeniably demonstrates that the American government has given the pharmaceutical industry a blank check to pillage the federal Treasury through the section 936 tax credit." /9/

THE RELATIONSHIP BETWEEN SECTION 936 AND TRANSFER PRICING ABUSE:

The cost ineffectiveness of section 936 generally testifies to the

Indeed, the data since 1982, the year in which the amendments were promulgated, show the continued role of transfer pricing in artificially increasing the profit rates of the possessions corporations. For example, in 1983, the reported before-tax annual rate of return on operating assets for manufacturing corporations participating in the section 936 program was 54.1 percent, more than five times the rate of return for mainland manufacturing operations (10.3 percent). /10/ If the true rate of return for section 936 investments in Puerto Rico were this high, firms would have strong incentives to increase their real investment on the island, and investment should be booming. However, this has not been the case. /11/ In 1988, for example, total fixed investment in Puerto Rico was about 20 percent of GNP, compared to 25 percent in the period 1966- 73. What this suggests is that the TEFRA amendments are still allowing corporations to transfer large amounts of income into Puerto Rico without a corresponding increase in the amount of their real investments. Yet, the 936 lobby was able to convince the Reagan Administration to continue to rely on the 936 tax subsidy as a development tool for the Caribbean Basin.

FOOTNOTES TO SECTION IV.

/1/ U.S. Department of the Treasury, "Sixth Report," p. 19.

/2/ Id.

/3/ National Bureau of Labor Statistics, by phone, August 1993. This rate of migration is currently hovering around one percent per year. See J.T. Hexner et al., Puerto Rican Statehood, p. 5.

/4/ Id., pp. 25-26.

/5/ U.S. Congressional Budget Office, "Potential Economic Impacts of Changes in Puerto Rico's Status under S.712." report prepared for the U.S. Senate Committee on Finance, April 1990. Table 3.

/6/ U.S. General Accounting Office, "Pharmaceutical Industry," p. 21.

/7/ Id.

/8/ Id., p. 6.

/9/ Richardson, "Pryor Blasts Drug Company Tax Breaks with GAO Ammunition," Tax Notes International (May 25, 1992): 1093.

/10/ U.S. Department of the Treasury, "Sixth Report," p. 36.

/11/ Hexner et al., Puerto Rican Statehood, for a discussion of why section 936 is incompatible with Puerto Rico's sustainable economic development and why statehood presents a much more efficient vehicle for continued growth.

END OF FOOTNOTES

V. SECTION 936 AND THE CARIBBEAN BASIN INITIATIVE

TARGETING SECTION 936 AT THE BROADER GOALS OF REGIONAL DEVELOPMENT

The Caribbean Basin Initiative (CBI) was introduced by the Reagan

TRA imposes a number of requirements regarding when earnings of section 936 firms will qualify for investment in a CBI country or possession. The first requirement is that investments can only be made in qualified Caribbean Basin countries as designated under the Caribbean Economic Recovery Act of 1983. /5/ Twenty-three countries have thus far qualified and are so designated. /6/ To be eligible for these tax-exempt investments, CBI-qualified countries are required to enter into a Tax Information Exchange Agreement (TIEA) with the United States. /7/ The purpose of the TIEA is to allow the United States and CBI governments to share tax and other information that could lead to the arrest of drug traffickers, tax evaders, and other criminals. /8/

Another requirement for these investments is that they be in "active business assets" or "development projects." /9/ The Senate Finance Committee Report that accompanied the CBI amendment to section 936 defines these as:

A development project generally means an infrastructure

Treasury Department regulations further define these terms so that

A section 936 company cannot receive a tax exemption if it invests funds directly in an otherwise-qualified CBI project. Instead, the section 936 company must invest through a "qualified financial institution." /12/ The Government Development Bank for Puerto Rico and the Puerto Rico Economic Development Bank are both defined as qualified financial institutions. Other than those two, in Puerto Rico, a financial institution may qualify if it is a "banking, financing or similar business" that is "organized under the laws of the Commonwealth of Puerto Rico or is the Puerto Rican branch" of such a business, and that is an eligible depository institution for investments from section 936 firms, as qualified by the Commissioner of Financial Institutions under Puerto Rican regulations; or "such other entity as may be determined by the Commissioner"; or a "single- purpose entity" established in Puerto Rico as an eligible institution solely to invest funds from section 936 firms in qualified CBI assets. /13/

All lending of these funds to a qualified CBI recipient must be approved by the Commissioner of Financial Institutions for Puerto Rico. /14/ Additionally, the recipient of CBI funds must open its books to the United States and Puerto Rican governments to assure that the funds are being used in accordance with the law. /15/ A 1990 Congressional amendment to section 936 requires the government of Puerto Rico to ensure that at least $100 million be invested annually in qualified CBI investments. /16/

EVALUATION OF THE CBI: A WEAK JUSTIFICATION FOR PROLONGING

Even among those who acknowledge the transfer pricing abuses of section 936 firms. there are proponents who justify the continued extension of section 936 benefits because of the tax credit's involvement with the CBI program. They argue that any elimination or reduction in the section 936 tax credit would proportionately damage the CBI because of the close integration of the two programs. It has been asserted, for example, that at least $500 million of qualified funds have been appropriately invested under this program, creating close to 20,000 jobs in the CBI countries and more than 2,500 jobs in Puerto Rico. /17/ These statistics have been used to support the claim that the program is functioning as intended and that section 936 should remain untouched.

Other evidence, however, suggests that the CBI program has been unsuccessful. The Latin American and Caribbean Economic Commission reported an average 17.2 percent reduction in per capita gross domestic product during the 1980s. /18/ Latin America and the Caribbean also experienced a 0.8 percent decrease in real gross national product in 1990, and record loans in that year added to their already staggering foreign debts. /19/ Thus, in relative terms, the very nations which the CBI was intended to support have been steadily losing ground. /20/ The claim of positive long-run development impact from the $500 million of CBI funds purported to have been allocated and the 20,000 jobs created in the CBI countries is dubious at best.

Despite the preferential treatment offered to CBI countries under the program, there has been a constant decline in the value of U.S. imports from these countries. U.S. imports from CBI countries reached an all-time high in 1983, the year in which the program was enacted. /21/ Between 1983 and 1986, however, exports from the CBI countries to the United States declined by a total of 31 percent. /22/ By contrast, the level of U.S. exports to these countries has remained steady. /23/ According to the U.S. International Trade Commission,

In 1986 for the first time in a number of years, the United

Also, in 1986, U.S. imports from CBI countries represented only 1.7

Recent data suggest a continuation of these trends. In 1990, U.S. imports from CBI countries were approximately $1.4 billion less than in 1983. /26/ This constitutes a 2.1 percent annual rate of reduction in the amount of imports and a 16 percent gross decline. /27/

Indeed, the Caribbean Basin Initiative might be judged as a program of phantom benefits and phantom results. Over 93 percent of the exports generated from Caribbean countries designated under this program already entered the United States duty-free prior to the enactment of the CBI. /28/ In addition, the elimination of already low U.S. tariffs (generally ranging from five to seven percent) on Caribbean industrial products does not make these products significantly more competitive in the U.S. market. /29/ Moreover, the CBI excludes from its list of qualified products a number of items produced by the most labor-intensive industries, including apparel and leather goods.

What the CBI program has successfully done, however, is to expand the scope of political leverage for section 936 companies by broadening the scope of their potential investment. As dollars have been invested in more CBI countries, section 936 companies have gained increasing clout with these countries and enlisted their help in lobbying against the curtailment of the tax credit. Nevertheless, because of the lack of real benefits from the CBI and because the actual amount of imports from the CBI countries has been steadily decreasing while U.S. exports have remained steady, the continued existence of the section 936 tax credit cannot be justified by linking it to the CBI program.

FOOTNOTES TO SECTION V.

/1/ The Caribbean Basin Initiative is the common name of the Caribbean Basin Economic Recovery Act, Pub. L. No. 98-67, 97 Stat. 384 (1983) (codified as amended in scattered sections of 19 U.S.C. and 26 U.S.C.). Under the act, qualified countries receive a reduction or elimination of tariffs on certain products, along with access to relatively low interest rate loans, provided with certain section 936 funds.

/2/ I.R.C. Sec. 936(d)(2).

/3/ I.R.C. Sec. 936(d)(2)(B) and 936(d)(4).

/4/ 13 L.P.R.A. Sec. 256a(2)(j)(A).

/5/ I.R.C. Sec. 936(d)(4).

/6/ Those countries and possessions are Antigua and Barbuda, Aruba, The Bahamas, Barbados, Belize, British Virgin Islands, Costa Rica, Dominica, Dominican Republic, El Salvador, Grenada, Guatemala, Guyana, Haiti, Honduras, Jamaica, Montserrat, Netherlands Antilles, Panama, St, Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and Trinidad and Tobago. Nicaragua has requested designation, and the U.S. is currently reviewing that request.

/7/ I.R.C. Sec. 936(d)(4)(B).

/8/ Flax-Davidson, "Tax-Exempt Investment for the Caribbean Basin Initiative Region," International Lawyer 25, no. 4 (Winter 1991): 1025.

/9/ I.R.C. Sec. 936(d)(4)(A)(i).

/10/ U.S. Senate, Committee on Finance, Tax Reform Act of 1986, S. Rep. No. 313, 99th Cong., 2d Sess. 384 (1986).

/11/ "Requirements for Investments to Qualify under Section 936(d)(4) as Investments in Qualified Caribbean Basin Countries," Treas. Reg. Sec. 1.936-10(c)(4), (5) (May 10, 1991).

/12/ I.R.C. Sec. 936(d)(4)(A).

/13/ Treas. Reg. Sec. 1.936-10(c)(3).

/14/ I.R.C. Sec. 936(d)(4)(A)(ii).

/15/ I.R.C. Sec. 936(d)(4)(C)(iii).

/16/ See I.R.C. Sec. 936(d)(4)(D) (West Supp. 1991) (effective for calendar years after 1989); H.R. 1594, 101st Cong., 2d Sess., 136 Cong. Reg. H5887, H5896 (daily ed. July 30, 1990).

/17/ Price Waterhouse, "Section 936 Report, Volume 1: Benefits and Costs of Section 936," prepared for Puerto Rico, U.S.A. Foundation, May 1991, Table IV.B. See also R.J. Sierra, Jr., "Funding Caribbean Basin Initiative Activities with Section 936 Funds," International Tax Journal (Spring 1992): 57-58.

/18/ "Mexico, Central American Countries Plan Free Trade Agreement to Be Reached by 1996," Intl. Trade Rep. (BNA) 8, no. 3 (Jan. 16, 1991): 87.

/19/ "Latin American Economies Register Decline of 0.8 Per Cent in 1990, IDB Report Shows," Intl. Trade Rep. (BNA) 8, no. 15 (Apr. 10, 1991): 554.

/20/ J.C. Malloy, "The Caribbean Basin Initiative: A Proposal to Attract Corporate Investment and Technological Infusion via an Inter- American Protection for Intellectual Property," University of Miami Inter-American Law Review 23, No. 1 (1991): 184.

/21/ U.S. International Trade Commission, "Annual Report on the Impact of the Economic Recovery Act on U.S. Industries and Consumers, Second Report 1986," September 1987, p. 6.

/22/ Id., p. 8.

/23/ Id., p. 1.

/24/ Id.

/25/ Id.

/26/ U.S. Department of Commerce, Guidebook: Caribbean Basin Initiative (1991), p. 55.

/27/ Id.

/28/ T.L. Raleigh, "The U.S. Caribbean Basin Initiative," International Business Lawyer 15, no. 3 (March 1987): 137.

/29/ Id.

END OF FOOTNOTES

VI. 1993 REFORMS AFFECTING SECTION 936

Section 482 Temporary Regulations on Transfer Pricing

Section 482 of the Treasury Regulations provides most of the guidelines concerning the proper allocation of income in a transfer pricing transaction. In an effort to provide a simpler, more workable set of transfer pricing rules, in January 1993 the Internal Revenue Service released temporary revisions to section 482 regulations, /1/ which went into effect on April 21 of this year. /2/ These regulations have, however, received constant criticism regarding their complexity, lack of clarity, and ineffectiveness. /3/

The current temporary regulations provide explicitly for coordination with section 936. Specifically, where a controlled taxpayer has elected for cost sharing, under section 936(h) the amount of the required cost sharing payment may not be less than the payment that would be required under section 482. /4/

The temporary section 482 regulations reaffirm that the purpose of section 482 is to ensure that transactions between taxpayers under common control ("controlled transactions") are conducted in a manner that accords with the arm's length standard. /5/ That is, the income that is derived from such transactions must be consistent with the result that would stem from a comparable transaction, under comparable circumstances, conducted between taxpayers who are NOT under common control ("uncontrolled transaction"). To the extent that income derived from controlled transactions is inconsistent with the arm's length standard, section 482 temporary regulations authorize the IRS to reallocate income, deductions, credits, allowances, or other elements that affect taxable income among the group of controlled taxpayers. /6/

The Comparability of Transactions

The factors determining the comparability of transactions and circumstances are described in the section 482 temporary regulations. Transactions that are comparable are not necessarily identical. Rather, they must be sufficiently similar so that, with reasonable adjustments, they can provide a reliable benchmark for an arm's length result. /7/ In keeping with these provisions, the taxpayer and, in the case of an audit, the IRS, must take into account the following considerations:

1. The similarity in the functions of controlled and

2. The similarity of the assumed risks under controlled and

3. The comparability of contractual terms;

4. The similarity of the economic conditions that surround the

5. The comparability of the property or service that is

These factors must also be examined in cases where controlled and

Section 482 regulations offer a menu of pricing methods to apply to two or more uncontrolled transactions in order to derive a RANGE of arm's length results (the arm's length range). The IRS does not reallocate income within the controlled group when the results of a controlled transaction fall within this range. /10/

The temporary regulations provide three methods for the pricing of transfers of intangible property: /11/ (1) the comparable uncontrolled transactions method; (2) the comparable profits method; and (3) any other reasonable method for cases where neither of the provided methods can be reasonably applied. /12/

The Comparable Uncontrolled Transactions Method

Under the comparable uncontrolled transactions method (CUT), the arm's length price for a controlled transfer of intangible property is equal to the price charged or cost incurred in a comparable uncontrolled transaction. /13/

To the extent that the CUT method can be reasonably applied on the basis of available information, a reasonable number of adjustments, and the existence of an active market and contemporaneous uncontrolled transactions involving comparable products, it generally provides the most accurate measure of an arm's length price.

The Comparable Profits Method

The comparable profits method (CPM) /14/ computes an arm's length result with reference to an objective profitability measure for comparable uncontrolled taxpayers. It may be applied in cases involving the transfer of tangible or intangible property. The accuracy of this pricing method relies on the availability of comparable uncontrolled taxpayers who engage in transactions similar to the transfers undertaken by the controlled group. /15/ However, since CPM focuses primarily on a financial ratio (for example, operating profit to operating assets, or operating profit to sales), its application requires the smallest degree of comparability between the controlled and uncontrolled transactions. /16/

CPM falls to provide an accurate arm's length result in cases that involve valuable, "non-routine" intangibles that are either "self-developed" or acquired from uncontrolled taxpayers under conditions in which the purchaser assumes high risks and yields. /17/ In such circumstances, it will often be impossible to locate comparable uncontrolled taxpayers.

Other Methods

When none of the above methods can reasonably be applied to the facts and circumstances of a particular case, another "reasonable" method may be used. /18/ The application of such a method will generally occur when the value of the property that is transferred reflects an unusual combination of tangible and intangible elements. As with the aforementioned pricing methods, specific disclosure and documentation requirements apply.

The "Best Method Rule"

Given the multiplicity of pricing methods, the temporary regulations supply a "best method rule" for selecting the appropriate method for use. Under this rule, any method may be applied without first disproving the applicability of other methods. If, however, subsequent demonstration suggests that an alternative method offers a more accurate determination of an arm's length result, the more accurate method should be applied. For each case, the completeness and accuracy of data, the degree of comparability between controlled and uncontrolled transactions, and the extent and necessity of adjustments are all factors to be used to determine the suitability of a pricing method. /19/

Annual Adjustments

If an intangible is transferred for a period that exceeds one year, the temporary regulations generally require annual adjustments to the consideration pricing to ensure that it remains consistent with the income attributable to the intangible. Under certain conditions, when the controlled taxpayers must have entered into a written agreement concerning the terms of the transfer of the intangible(s), no such reallocation will be made by the IRS. The conditions vary somewhat, depending on the pricing method used, but in all cases the consideration in the agreement must be an arm's length amount. Moreover, the aggregate profits earned, or the total cost savings actually realized by the controlled taxpayer, from the exploitation of the intangible, must not be less than 80 percent nor more than 120 percent, of the profits or cost savings that were anticipated when the agreement was executed. /20/

Possible Effects of Section 482 Temporary Regulations on Section 936

The temporary section 482 regulations, issued in January 1993 and effective on April 21, 1993, contain provisions that alter the manner in which transfer prices for intangible property will be reviewed by the IRS and that specifically coordinate with the transfer pricing requirements of section 936. The new section 482 temporary regulations provide for greater taxpayer flexibility, at the cost of more stringent documentation requirements. /21/ The IRS anticipates that this will diminish the number of disputes between the IRS and taxpayers. /22/ Some practitioners contend, however, that the policy, in its move toward greater flexibility, imposes an unmanageable administrative burden on the IRS.

The temporary regulations reaffirm the applicability of the arm's length standard and continue to emphasize analysis that relies on the structure and circumstances of the individual transaction. However, added flexibility now comes via the applicability of a range of acceptable arm's length results as opposed to a single arm's length price. Also, consistent with the reality of varying market conditions and transaction circumstances, there is now no strict priority of pricing methods. Instead, the accuracy of the pricing method, with respect to the case in question, decides its appropriateness. In another move towards taxpayer flexibility, the prices actually charged in controlled transactions need not reflect the arm's length price that must be reported on the income tax return. Where reported price differs from the price actually charged, compensating adjustments are made to reflect the disparity. /23/ Finally the standards that must be met before transactions are considered comparable have been relaxed. Under all pricing methods, a reasonable number of adjustments are permitted where transactions are not exactly comparable.

With regard to possessions corporations, section 482 regulations provide that when a controlled taxpayer has elected for cost sharing under section 936(h), the amount of the cost sharing payment that is required under this section will not be less than the payment that would be required under the section 482 regulations (if the electing taxpayer were a foreign corporation). Also, the 936 corporation must apply the section 482 pricing methods for intangibles before giving effect to the provisions that treat the 936 corporation as the owner of this property.

One reviewer of the tax changes makes the following claim:

It is almost impossible using the arm's length method of section

This claim is troubling given the findings of a recent Ernst & Young

In effect, the complexity of the new temporary section 482 regulations has the potential to render them unadministerable. Indeed the true price of taxpayer flexibility is that the circumstances of transfer pricing arrangements will gain in subjectivity and will increasingly call for judgment on a case-by-case basis. Accordingly, cases involving highly differentiated products, for which benchmark arm's length transactions are not easily identified (more often true of intangibles), will rely on extensive cost, pricing, and market data -- often from unwilling competitors.

In practical terms, then, the auditing requirements of the policy leave the short-staffed IRS at a disadvantage compared to the multinational corporations with their batteries of highly paid lawyers, accountants, and economists.

FURTHER LIMITATIONS ON THE SECTION 936 TAX CREDIT

As a result of concerns about transfer pricing abuse by pharmaceutical and other capital-intensive firms and because of the low levels of employment-producing investments made by section 936 firms, section 936 has been increasingly opposed by the U.S. Treasury Department and members of Congress. Indeed, on December 31, 1993, legislation designed to curb transfer pricing abuses and increase levels of investment in employment-producing activities, enacted as part of the Omnibus Budget Reconciliation Act of 1993, will go into effect. /26/

Under the new legislation, the section 936 credit will be calculated in a manner consistent to that used prior to December 31, 1993. /27/ However, the amount of the credit will then be limited in one of two ways, /28/ with the choice of method left to the taxpayer. The first, the percentage limitation, limits the credit by a statutorily defined percentage (that decreases in future years) of the section 936 credit allowable under present law. The second alternative, the economic activity limitation, links the limitation on the credit to a composite of factors that serve as proxy for the firm's level of economic activity in the possessions. All affiliated /29/ possessions corporations are required to choose the same credit- limitation alternative. /30/

THE PERCENTAGE LIMITATION

Under the percentage limitation, the section 936 credit allowed to a possessions corporation against U.S.A tax on business income for a tax year is limited to a specific percentage of the credit that would be permitted under the laws prior to revision. A five-year transition rule governs the phase-in. The percentages are:

     START OF TAX YEAR             PERCENTAGE LIMITATION

          1994                               60

A taxpayer that utilizes the percentage limitation is permitted a deduction for a portion of its possession income taxes paid or accrued during the tax year. The portion of the taxes so deductible is the portion that is allocable to the corporation's taxable income, the U.S. tax on which is not offset by the section 936 credit as a result of the limitation.

EXAMPLE NO. 5

XYZ is a possessions corporation operating in the 1998 tax year

Further, XYZ incurred $60,000 in possession taxes. A partial

The percentage limitation clearly reduces the section 936 credit over time. However, a firm's choice to use this alternative will be a function of the magnitude of its potential credit in relation to the credit available under the economic activity limitation. This will of course be determined by the firm's capacity to claim credit from the expansion of new labor-intensive activities as well as activities that purport to be so.

THE ECONOMIC ACTIVITY LIMITATION

The sum of three proxy measures for economic activity in the possessions serves as an upper limit for the tax credit allowed to a possessions corporation for a tax year. The credit against U.S. tax on the possessions corporation's business income may not exceed the sum of the following components:

(1) 60 percent of qualified compensation;

(2) the applicable percentages of depreciation deductions on

(3) a portion of the possession income taxes incurred during a

U.S. tax liability is therefore computed by subtracting the sum of

QUALIFIED COMPENSATION

The first component of the economic activity limitation is 60 percent of qualified compensation. Qualified compensation is the sum of (1) the aggregate amount of the possessions corporation's qualified possessions wages for the tax year /31/ and (2) allocable employee fringe benefit expenses for the tax year. /32/ Qualified possessions wages are defined as wages paid or incurred by the possessions corporation during the tax year to any employee for services performed in a possession. However, such services must be performed while the principal place of employment of the employee is within that possession.

DEPRECIATION DEDUCTIONS

The second component is the sum of the following applicable percentages of allowable depreciation deductions:

(1) 15 percent of the depreciation deductions allowable to

(2) 40 percent of the depreciation deductions allowable to

(3) 65 percent of the depreciation deductions allowable to long-

POSSESSION INCOME TAXES

The final component of the economic activity limitation is a portion of the income taxes paid or incurred to a possession by corporations that do not elect the profit-split method. /34/ Possession income taxes paid in excess of a 9-percent effective rate of tax are not included. Moreover, only the portion of taxes that satisfy this effective rate requirement and that are allocable to nonsheltered income is included. /35/

EXAMPLE NO. 6

XYZ is a possessions corporation that elects to use the

Under the laws in effect through the end of 1993 (assuming

The revised section 936 law does not change the credit

QUALIFIED COMPENSATION

Qualified possession wages amount to $150,000. Potentially,

DEPRECIATION DEDUCTIONS

The depreciation component of the credit limitation is the

POSSESSION INCOME TAXES

None of the $60,000 of possession income taxes (a 6%

In the absence of the compensation and depreciation

With no section 936 credit, the U.S. income tax liability

The amount of possession income taxes which may be included

TOTAL ECONOMIC ACTIVITY LIMITATION

The total limitation on the active business credit is

FOOTNOTE TO EXAMPLE 6

/a/ Taxable income is computed in accordance with the pre- December 31, 1993, rules for determining the taxable income of a possessions corporation.

END OF FOOTNOTE

ELECTION TO TREAT AFFILIATED CORPORATIONS AS ONE CORPORATION

For the purposes of computing the economic activity limitation, the bill allows an affiliated group of corporations to elect to treat all affiliated possessions corporations as one corporation. For a group so electing, the available consolidated credit amount is to be allocated among the possessions corporations of the group under rules prescribed by the Treasury Secretary. Any election to consolidate applies to the tax year for which such election is made and to all succeeding tax years unless revoked with the consent of the Treasury Secretary.

ANALYSIS OF THE ECONOMIC ACTIVITY LIMITATION

In concept, over the course of five years, section 936 credits will be effectively linked to growth in employment wages and tangible investment. From a practical standpoint, however, the policy is less promising.

INCREASED ADMINISTRATIVE COMPLEXITY The correlation between tax avoidance and development strategies based on complex tax incentive schemes is well established. Indeed, the compounding negative results of repeated efforts by Congress to patch the loopholes of section 936 verify this correlation.

The revisions to section 936 made by the Omnibus Budget Reconciliation Act of 1993 significantly increase administrative complexity and auditing. This, in turn, enhances the potential for tax avoidance by presenting new opportunities for tax manipulation of corporation expenses and transfers to maximize tax benefits under section 936. Payroll padding, for example, is certain to replace transfer pricing as a means of increasing the credit to 936 firms in the absence of substantive real growth in employment and investment.

UNFAIR TO PUERTO RICAN FIRMS AND DETRIMENTAL TO THE PUERTO RICAN TREASURY After December 31, 1993, Puerto Rican firms, which pay a 42- percent income tax rate will be forced into unfair competition with firms from the mainland. Mainland firms will benefit not only from Puerto Rican tax incentives but also from the tax credits that subsidize 60-percent of wages in section 936 firms and significant percentages of depreciation on tangible investment. This carries the possibility of destroying the Puerto Rican entrepreneurial initiative.

Because the revised section 93 policy ties the tax credit directly to wages and other costs, it will create harmful economic distortions. Possessions corporations will have an incentive to expand their wage bill to maximize their section 936 tax credits. Section 936 firms may most easily accomplish this by doing more activities within the firm by hiring more employees, reducing procurement from Puerto Rican companies ("outsourcing"), and/or buying out Puerto Rican firms in order to increase their payrolls.

As those Puerto Rican industries now operating with no tax incentives consolidate with section 936 firms, Puerto Rican corporation income tax revenues will diminish. Moreover, the policy may reduce the viability of Puerto Rican-owned suppliers to section 936 firms.

THE REVISED SECTION 936 FURTHER ENTRENCHES DETRIMENTAL POLICY Payroll and employment expansion under tee revision will not be market based and will be unsustainable in the absence of the tax credit. Accordingly, the tax credit will foster a dependence not just on the part of U.S. multinationals but also by Puerto Rican workers, whose livelihoods will increasingly be directly dependent upon revenues foregone by the U.S. Treasury.

Relatively high mainland unemployment and the salience of the Clinton Administration's calls for sacrifice on behalf of the U.S. budget deficit and health care reform will, at the same time, make section 936 increasingly unpalatable to mainland residents.

FOOTNOTES

/1/ With the adoption of the temporary regulations, proposed section 482 regulations dating to January 1992 have, with the exception of the cost sharing provisions, been withdrawn. In addition, new relevant proposed regulations, as of January 1993, include a description of a profit-split pricing method under section 482 regulations and the penalty regulations that would apply to transfer pricing valuation misstatements.

/2/ J. Turro, "Practitioners Give New Transfer Pricing Regs Positive Review," Tax Notes (January 25, 1993): 389.

/3/ A. Huddleston, "Kellogg Management School Conducts Conference on Transfer Price Regs," Tax Notes 58, no. 8 (February 22, 1993): 1015.

/4/ Temp. Reg. Sec. 1.482-1T(f)(2) (1993).

/5/ Temp. Reg. Sec. 1.482-1T(a)(1).

/6/ Temp. Reg. Sec. 1.482-1T(a)(2).

/7/ Temp. Reg. Sec. 1.482-1T(c)(2)(i).

/8/ Temp. Reg. Sec. 1.482-1T(c)(3).

/9/ Temp. Reg. Sec. 1.482-(c)(4).

/10/ Temp. Reg. Sec. 1.482-1T(d)(2).

/11/ The temporary section 482 regulations prescribe five methods for determining the arm's length consideration for the sale of tangible property: (a) the comparable uncontrolled price method, (b) the resale price method, (c) the cost plus method, (d) the comparable profits method, and (e) other methods. With the exception of the addition of the comparable profits method (CPM) (which is analogous to the CPM for intangibles), the pricing methods for tangibles, as provided in the temporary regulations, are not substantively different from the regulations that existed prior to 1993.

/12/ Temp. Reg. Sec. 1.482-4T.

/13/ Intangible property that is involved in both controlled and uncontrolled transfers will be considered comparable when it: (a) involves the same class of intangible property; (b) relates to the same type of product or industry; and (c) carries substantially the same profit potential. The circumstances surrounding the transfer are considered comparable if there are comparable contractual terms and economic conditions. Temp. Reg. Sec. 1.482-4T.

/14/ Temp. Reg. Sec. 1.482-5T.

/15/ Given that CPM will generally involve several comparable parties, a range of acceptable results are used. Termed "constructive operating profits" (COP), this range is calculated by measuring the profit-level indicators of various uncontrolled taxpayers. If the tested party's operating profits fall within the COP range, no reallocation is necessary. Temp. Reg. Sec. 1.482-5T.

/16/ Temp. Reg. Sec. 1.482-5T(c).

/17/ Temp. Reg. Sec. 1.482-5T(a).

/18/ Temp. Reg. Sec. 1.482-4T(d).

/19/ Temp. Reg. Sec. 1.482-1T(b)(2)(iii).

/20/ Temp. Reg. Sec. 1.482-4T(e)(2)(i).

/21/ A. Huddleston, "Conference on Transfer Price Regs," p. 1015.

/22/ J. Turro, "Practitioners Give Positive Review."

/23/ Temp. Reg. Sec. 1.482-1T(e)(2).

/24/ Lobel, Banta, and Gueron, "Barclays: A Test of the Administration's Willingness To Collect Taxes from Multinational Corporations," Tax Notes (June 28, 1993): 1841.

/25/ Id.

/26/ See H.R. 2264, 103rd Congress, 1st Sess.

/27/ Under the new legislation, there is a new separate foreign tax credit limitation category for computing the alternative minimum tax (AMT) foreign tax credit. The new category includes the portion of dividends received from a possessions corporation for which the dividends-received deduction is generally disallowed, and thus is included in alternative minimum taxable income.

/28/ In a measure to support Puerto Rican tax revenues, given the credit limitations, the revised legislation temporarily increases the cover-over of rum excise taxes to Puerto Rico and the Virgin Islands from $10.50 to $11.30 per proof gallon. The increased cover- over rate applies through 1998.

/29/ The consolidation return rules are used to determine whether a possessions corporation is part of an affiliated group. However, stock owned by attribution under the rules of section 1563 is treated as if it were owned directly, and the exclusions from the definition of "includible corporation" listed in section 1504(b) are disregarded.

/30/ Should a possessions corporation that employs the percentage limitation become a member of a group that uses the economic activity limitation, then the first corporation will be deemed to have revoked its election to use the percentage limitation. The Treasury Secretary is authorized through Treasury to develop regulations to treat two or more possessions corporations as members of the same affiliated group in order to prevent avoidance of the consistency rule.

/31/ Wages for this purpose include those defined under the Federal Unemployment Tax Act (FUTA). In computing the credit limitation for a tax year, the cumulative amount of wages for each employee may not exceed 85 percent of the maximum earnings subject to tax under the Old Age Survivors and Disability Insurance (OASDI) portion of Social Security (currently $57,600). Rules for making appropriate adjustments to this limit for part-time employees and employees whose principal place of employment is not within a possession for the entire tax year are to be made by the Treasury Secretary. The bill does not include as qualified possession wages amounts paid to employees who are assigned by the employer to perform services for another person, unless the principal trade or business of the employer is to make employees available for temporary periods to other persons in exchange for compensation.

/32/ Fringe benefits may include (1) employer contributions under a stock bonus, pension, profit sharing, or annuity plan; (2) employer-provided coverage under any accident or health plan for employees; and (3) the cost of life or disability insurance provided to employees. Fringe benefit expenses do not include any amount that is treated as wages. Allocable employee fringe benefit expenses are equal to a fraction of the aggregate amount that is consistent with the conditions listed above. The numerator of this fraction is the aggregate amount of the possessions corporation's qualified possessions wages (as defined above). The denominator is the aggregate amount of compensation (wages and benefits) paid or incurred during the tax year. Fringe benefit expenses may not, however, exceed 15 percent of the aggregate amount of qualified possession wages for that year.

/33/ The terms of section 168 apply to the definition and classification of depreciable tangible property.

/34/ Possessions corporations that utilize the profit-split method may deduct a portion of their possession income taxes paid or accrued during the tax year. This portion is the part of U.S. taxable income, the U.S. tax on which is not offset by the revised section 936 credit.

/35/ The portion of possession income taxes allocated to non- sheltered income is determined by computing the ratio of two hypothetical U.S. tax amounts that are computed under the assumption that no credit or deduction is allowed for possession income taxes. This ratio is then multiplied by the taxable income of the corporation as computed under the assumption that no credit or deduction is allowed for possession income taxes, and that all other deductions are allowed as under present law.

The numerator of the above ratio is the U.S. tax liability of the possessions corporation that would arise under the bill by virtue of the economic activity limitation determined without any credit or deduction for possession income taxes. The denominator is the U.S. tax liability of the possessions corporation that would be imposed on the income (computed under existing section 936 rules) of the corporation without any credit or deduction for possession income taxes.

END OF FOOOTNOTES

VII. CONCLUSION

Section 936 has ceased to be an efficient means of attaining employment-producing investments in Puerto Rico and other U.S. possessions. While the initial rationale for the credit was the creation of jobs and the stimulation of economic activity in the possessions, the outcome has been far different. Capital-intensive firms now take advantage of transfer pricing laws to maximize profits without making the intended investments. This is shown by the enormous rate of return on operating profits by the possessions corporations (five times the rate of return for mainland manufacturing operations) and by the fact that in the pharmaceutical industry, which currently claims the majority of section 936 credits, the average cost to the U.S. Treasury per job created is twice the average salary in that industry in Puerto Rico.

The fundamental questions then are: Can the long record of disappointment be ended? And, can the legislation provided in the 1993 budget transform section 936 into an instrument of public benefit, rather than of private profit? Given the requirements of sustainable Puerto Rican economic growth and the constraints of the U.S. federal budget, we conclude that the costs of section 936 will continue to outweigh its benefits.

BIBLIOGRAPHY

Aud and Fuller. "The New Temporary and Proposed Section 482 Regulations: A Wolf in Sheep's Clothing?" Tax Notes 58, no. 11 (March 15, 1993): 1517-37.

Avakian-Martin, Juliann. "IRS Acknowledges Need to Clarify Portions of Transfer-Pricing Regs." Tax Notes 54, no. 12 (March 23, 1992): 1452-53.

Bell and Turro. "Prior Bill Targets Possessions Credit, Pharmaceutical Companies." Tax Notes 58, no. 8 (February 22, 1993): 1005-6.

Boles, Richard J. "Tax Incentives for Doing Business in Puerto Rico." International Lawyer 22. no. 1 (Spring 1988): 121-42.

Bradford, John J. "U.S. Possessions Corporations Retums, 1989." U.S. Department of the Treasury, Office of Tax Analysis.

Caribbean Basin Initiative: Caribbean Views; Report of a Congressional Study Mission and Symposium on the Caribbean Basin Initiative September 18-19 to the Committee on Foreign Affairs, U.S. House of Representatives. December 1987.

Caribbean Basin Initiative: Hearing before the Subcommittee on International Trade of the Committee on Finance, United States Senate, 101st Cong., 2d Sess. February 9, 1990.

Carlson, George N. "The Proposed New Transfer Pricing Rules: New Wine in Old Bottle." Tax Notes 54, no. 6 (February 10, 1992): 691- 717.

Clark, Don P. "Measurement of Trade Concentration under the United States' Caribbean Basin Initiative." World Development 17, no. 6 (1989): 861-65.

Cole, Robert T. "Section 482: Proposed New Regulatory Approaches." Tax Executive 44, no. 2 (March-April 1992): 95-102.

Development Policy in the Caribbean: Hearings before the Subcommittees on Human Rights and International Organizations, International Economic Policy and Trade, and on Western Hemisphere Affairs of the Committee on Foreign Affairs, House of Representatives, 100th Cong., 2d Sess. July 28; August 4, 9 and 10, 1988.

Ekman, Mary Ann. "Mogle Discusses New Temporary and Proposed Section 482 Regulations at California State Bar Conference." Tax Notes International 6, no. 5 (February 1, 1993): 243-47.

Flax-Davidson. "Tax-Exempt Investment for the Caribbean Basin Initiative Region." International Lawyer 25. no. 4 (Winter 1991): 1021-29.

Fuller, James P. "The Proposed Section 482 Regulations." Tax Notes International 4, no. 12 (March 23, 1992): 599-612.

____. "Section 482 Transfer-Pricing Regulations." Tax Notes International 4, no. 9 (March 2, 1992): 438-40.

Granfield, Michael E. "An Economic and Strategic Evaluation of the Proposed Section 482 Regulations." Tax Notes International 4, no. 24 (June 15, 1992): 1255-69.

Gray, Tim. "Two Taxwriters Push Puerto Rico to Invest More Section 936 Funds." Tax Notes 47. no. 13 (June 25, 1990): 1551-52.

Hanlon, Sally. "GAO Questions Commerce Department's Portrayal of Impact of CBI." Tax Notes 33, no. 1 (October 6, 1986): 22-23.

Hexner, J. Tomas, Glenn Jenkins, Helen F. Ladd, and K. Russell LaMotte. Puerto Rican Statehood: A Precondition to Sound Economic Growth. Cambridge, Massachusetts: Hex Inc., November 1993.

Huddleston, Andrew. "Kellogg Management School Conducts Conference on Transfer Price Regs." Tax Notes 58, no. 8 (February 22, 1993): 1015-18.

Kirchheimer. Barbara. "Clinton Tax Proposals: Some Tinkering, No Major Surprises." Tax Notes 59, no. 2 (April 12, 1993): 152-54.

"Latin American Economies Register Decline of 0.8 Per Cent in 1990, IDB Report Shows." Intl. Trade Rep. (BNA) 8. no. 15 (Apr. 10, 1991).

Lederrnan, Alan S. "Proposed Section 482 Regs. Adopt Comparable Profit Interval Requirement." The Tax Magazine 70, no. 4 (April 1992): 228-42.

Lobel, Banta, and Gueron. "Barclays: A Test of the Administration's Willingness To Collect Taxes from Multinational Corporations." Tax Notes (June 28, 1993): 1841-44.

Lunger, Anilisa G. "The Caribbean Basin Initiative and the I.R.C. Section 936 Investment Program: A United States Answer to the Troubled Caribbean Region." University of Pennsylvania Journal of International Business law 9 (1987): 741-85.

Luxner, Larry. "High Hopes for Low-Interest Loans." Americas 43, nos. 5-6 (1991): 22-25.

Malloy, John Cyril, III. "The Caribbean Basin Initiative: A Proposal to Attract Corporate Investment and Technological Infusion via an Inter-American System of Cooperative Protection for Intellectual Property." University of Miami Inter-American Law Review 23, no. 1 (Fall 1991): 175-94.

McLennan, Barbara N. "Complying with the Proposed Section 482 Regulations: How to Create and Apply a Comparable Profit Interval." Tax Notes International 4, no. 23 (June 8, 1992): 1201-1216.

"Mexico, Central American Countries Plan Free Trade Agreement to Be Reached by 1996." Intl. Trade Rep. (BNA) 8, no. 3 (January 16, 1991).

Morrison, Philip. "Testimony before the Committee on Finance, United States Senate." April 26, 1990.

Mudd, John E. "The Impact of the Elimination of Section 936 of the Internal Revenue Code on U.S. Foreign Policy in the Caribbean." Revista de Derecho Puertorriqueno 27, no. 101 (Spring 1987): 25-45.

O'Grady, John E. "Cost-Sharing Arrangements under the Proposed Section 482 Regulations." Tax Notes International 4, no. 8 (February 24, 1992): 381-92.

Pelzman, Joseph. "The Impact of the Caribbean Basin Economic Recovery Act on Caribbean Nations' Exports and Development." Economic Development and Cultural Change 36, no. 4 (July 1988): 753-96.

____. "The Impact of the Caribbean Basin Economic Recovery Act on Caribbean Nations' Exports and Development: A Reply." Economic Development and Cultural Change 38, no. 4 (July 1990): 851-54.

Pinon, Gema M. "CBI II: Will United States Protectionist Tendencies Yield to Economic Development in the Caribbean Basin?" The University of Miami Inter-American Law Review 20, no. 3 (1989): 615- 43.

Price Waterhouse. "Section 936 Report, Volume 1: Benefits and Costs of Section 936." Prepared for Puerto Rico, U.S.A. Foundation, May 1991.

Raleigh, Thomas L., III. "The U.S. Caribbean Basin Initiative." International Business Lawyer 15, no. 3 (March 1987): 136-38.

Richardson. "Pryor Blasts Drug Company Tax Breaks with GAO Ammunition." Tax Notes International (May 25, 1992).

Rolfe, Robert J. "Combining the Benefits of Possessions Corporations with the Caribbean Basin Initiative." The International Tax Journal 16, no. 1 (Winter 1990): 5-22.

Romero, Carlos. "CBI Not Likely to Benefit from Section 936." Tax Notes 30, no. 6 (February 10, 1986): 547-49.

Santiago, Carlos Enrique. Labor in the Puerto Rican Economy: Postwar Development and Stagnation. New York: Praeger, 1992.

Sawyer, W. Charles. "The Impact of the Caribbean Basin Economic Recovery Act on Caribbean Nations' Exports and Development: A Comment on Pelzman and Schoepfle's Estimates." Economic Development and Cultural Change 38, no. 4 (July 1990): 845-49.

Sierra, Ralph J., Jr. "Funding Caribbean Basin Initiative Activities with Section 936 Funds." International Tax Journal 18, no. 2 (Spring 1992): 27-58.

Simpson. "Do You See 'Convergence'? Examples of Real-World Data and the Comparable Profit Interval of Proposed Regulation Section 1.482." Tax Notes International 4, no. 25 (June 22, 1992): 1311-18.

Tansill. "Puerto Rico: Independence or Statehood?" Revista del Colegio de Abogados de Puerto Rico 41 (1980): 79.

Turro, John. "Congress Asks Why Section 936 Funds Are Not Reaching the Caribbean." Tax Notes 47, no. 2 (April 9, 1990): 133-35.

____. "Section 482 Regulations Issued at Long Last; 'Comparable Profit' Analysis Introduced." Tax Notes International 4. no. 5 (February 3, 1992): 207-210.

_____. "Practitioners Give New Transfer Pricing Regs Positive Review." Tax Notes (January 25, 1993): 389.

____. "Clinton Looks to Foreign Provisions for Even More Revenue." Tax Notes 59, no. 2 (April 12, 1993): 155-56.

____. "Possessions Credit Reform Not a Done Deal, Treasury Official Implies." Tax Notes 59, no. 4 (April 26, 1993): 469.

"Puerto Rico Officials Unveil Section 936 Credit Proposal." Tax Notes 59, no. 5 (May 3, 1993): 597-98.

____. "White House Fine Tunes Foreign Provisions; Sticks to 936 Proposal." Tax Notes 59, no. 6 (May 10, 1993): 724.

U.S. Congressional Budget Office. "Potential Economic Impacts of Changes in Puerto Rico's Status under S.712." Report prepared for the U.S. Senate Committee on Finance, April 1990.

U.S. Department of Commerce. Bureau of the Census, Statistical Abstract of the United States, 1975-1985.

____. Guidebook: Caribbean Basin Initiative. 1991.

U.S. Department of the Treasury. "The Operations and Effect of the Possessions Corporation System of Taxation, Sixth Report." March 1989.

U.S. Department of the Treasury, Internal Revenue Service. "Intercompany Transfer pricing and Cost Sharing Regulations under Section 482." 26 CFR Part 1, January 30, 1992.

____. "Intercompany Transfer Pricing and Cost Sharing Regulations under Section 482, Hearing." 26 CFR Part 1, July 30, 1992.

U.S. General Accounting Office. "Pharmaceutical Industry: Tax Benefits of Operating in Puerto Rico." Briefing Report to the Chairman, Special Committee on Aging, U.S. Senate. May 1992.

U.S. House of Representatives. "Report of the Committee on Ways and Means, U.S. House of Representatives, on H.R. 10612." Report No. 94-658, November 12, 1975.

U.S. International Trade Commission. "Annual Report on the Impact of the Economic Recovery Act on U.S. Industries and Consumers, Second Report 1986." September 1987.

U.S. Senate. "Report of the Committee on Finance, United States Senate, on H.R. 10612." Report No. 94-938, June 10, 1976.

U.S. Senate, Committee on Finance. Tax Reform Act of 1986. S. Rep. No. 313, 99th Cong., 2d Sess. 384 (1986).

Wright, Delores R. "Living with the Proposed S. 482 Regulations." Tax Management Memorandum 33, no. 8 (April 20, 1992): S3-10.