UNITED STATES TAX COURT

116 T.C. No. 25

UNITED STATES TAX COURT

MEDCHEM (P.R.), INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

MEDCHEM PRODUCTS, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 4065-98, 4066-98.

Filed May 18, 2001.

P-USA is a corporation that is headquartered and

has its manufacturing facility in the United States.

Its wholly owned subsidiary is P-PR, which lists as its

headquarters, officers, and directors the headquarters,

officers, and directors of P-USA. A is a corporation

unrelated to Ps that manufactures in Puerto Rico a drug

named Avitene. On Dec. 18, 1987, A and certain related

entities sold to Ps the equipment, technology, and

other assets (except A’s manufacturing facility in

Puerto Rico) connected to Avitene’s manufacturing. As

part of the sale, A agreed to continue manufacturing

Avitene primarily for P-PR using the facility and labor

furnished by A and the raw materials and equipment

furnished by P-PR. (A also used P-USA’s technology.)

In return, P-PR generally agreed to pay A a fee equal

to its manufacturing costs plus 10 percent. Throughout

most of the relevant period, P-PR had no employees and

- 2 reported as its primary source of income receipts from

the sale of Avitene. P-PR deducted from those receipts

amounts that it paid to P-USA and A for labor that they

expended on Avitene’s manufacturing process. P-PR

claimed on its 1992 Federal income tax return that it

was entitled to a $1,993,264 Puerto Rico and possession

tax credit under sec. 936(a), I.R.C. Ps argue that PPR met the “active conduct of a trade or business

within a [U.S.] possession” requirement of sec.

936(a)(2)(B), I.R.C., by virtue of: (1) A’s activities

in Puerto Rico, (2) the fact that A manufactured

Avitene using P-PR’s raw materials and equipment, (3)

the fact that P-PR continued to own the raw materials

from the time that it received them until the time that

it sold them in their manufactured form as Avitene, and

(4) the fact that P-PR paid P-USA and A for the cost of

their labor connected to the Avitene manufacturing

process.

Held: P-PR did not actively conduct a trade or

business in Puerto Rico as required by sec.

936(a)(2)(B), I.R.C.; i.e., P-PR did not participate

regularly, continually, extensively, and actively in

the management and operation of a profit-motivated

activity in that possession.

David A. Hickerson, for petitioners.

Theodore J. Kletnick, Alan S. Kline, George Curran, Jennifer

Allan Kassabian, Marie E. Small, and Melanie A. Garger, for

respondent.

OPINION

LARO, Judge:

These consolidated cases were submitted to the

Court without trial.

See Rule 122.

Respondent determined an

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

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

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

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

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

Following

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

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

requirement of section 936(a)(2)(B).

We hold it does not.1

Unless otherwise indicated, section references are to the

Internal Revenue Code applicable to the relevant years.

Rule

references are to the Tax Court Rules of Practice and Procedure.

We attach hereto as appendix A a summary of some of the critical

events that occurred during:

(1) The 20½-month period from

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

test period relating to our determination under section

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

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

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

Background

The parties have filed with the Court a stipulation of facts

and certain related exhibits.

We incorporate herein by reference

1

Given that holding, we need not and do not decide the

parties’ other dispute; to wit, whether MedChem P.R. manufactures

or produces a product in the possession as required by sec.

954(d)(1)(A).

2

We take into account petitioners’ actions in years

subsequent to their 1992 taxable year to evaluate their prospects

during their 1992 year. See Levin v. Commissioner, 832 F.2d 403,

406 n.3 (7th Cir. 1987) (Tax Court allowed to rely on subsequent

events to determine whether those events were consistent with the

Court’s judgment of the facts available in the year in issue),

affg. 87 T.C. 698 (1986).

- 4 the stipulated facts and exhibits.

We find the stipulated facts

accordingly, and we set forth the relevant facts in this

background section.

MedChem Products, Inc. (MedChem U.S.A.), is a Massachusetts

corporation whose principal place of business is in Woburn,

Massachusetts (Woburn).

MedChem U.S.A. succeeded MedChem P.R.

following the subject years through a merger of the latter into

the former.

MedChem P.R. was incorporated in Delaware on

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

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

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

and it changed its name on November 25, 1992, to MedChem P.R.

MedChem P.R. and its predecessors (each hereinafter referred to

as MedChem P.R.) were always wholly owned subsidiaries of MedChem

U.S.A.

The original books and records of MedChem P.R. and MedChem

U.S.A. are maintained in Woburn on an accrual method of

accounting and on the basis of a fiscal year ending on August 31.

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

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

property income”, sec. 936(h)(3), attributable to the sale of

Avitene, a pharmaceutical manufactured in Puerto Rico by Alcon

Puerto Rico Inc. (Alcon P.R.), an unrelated entity.

Avitene is a

blood clotting drug that is manufactured from the interior

- 5 collagen-rich lining (corium) of cowhides.

surgery to control bleeding.

It is used during

It was primarily manufactured by

Alcon P.R. during the relevant years in the forms of 35x70 mm.

nonwoven web and 1 gram finished flour.

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

facilities in Woburn.

It leased 32,000 square feet in 1989, and

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

space.

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

50,000 square feet at two facilities in Woburn.

MedChem U.S.A.’s

144 full-time employees on August 31, 1992, worked at MedChem

U.S.A.’s manufacturing facilities in Woburn and San Antonio,

Texas.

The individuals who were connected with the Avitene

manufacturing and sales business (Avitene business) were employed

by MedChem U.S.A., MedChem P.R., Alcon P.R., or Kelly Services,

Inc. (Kelly), a supplier of temporary labor.

Each MedChem U.S.A.

employee connected with Avitene was paid by MedChem U.S.A. and

had his or her office at MedChem U.S.A.’s facility in Woburn.

MedChem P.R. had no employees after June 30, 1990.

MedChem

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

MedChem P.R. terminated him on June 30, 1990.

Nor did any of

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

Rico after June 30, 1990.

All of MedChem P.R.’s officers and

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

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

officers or directors was paid by MedChem P.R.

The individuals connected with the Avitene business are

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

period of affiliation in the listed capacity.

Name

Affiliate

Office

Location

Acosta, Eugenia

Alifonso, Ramon

Brophy, Frank

MedChem U.S.A.

Alcon P.R.

MedChem U.S.A.

Woburn

P.R.

Woburn

Carrion, Jimmy

Castro, Raymond

Donaldson, Jonathan

Alcon P.R.

Kelly, Alcon P.R.

MedChem U.S.A.

P.R.

P.R.

Woburn

MedChem P.R.

Woburn

MedChem U.S.A.

MedChem U.S.A.

MedChem U.S.A.

Woburn

Woburn

Woburn

MedChem P.R.

Woburn

Hansen, Lee

Micale, Domenic

Moran, Sean

Alcon P.R.

MedChem U.S.A.

MedChem U.S.A.

MedChem P.R.

P.R.

Woburn

Woburn

Woburn

McDonough, John

Perez, Jose

MedChem U.S.A.

MedChem P.R.

Woburn

P.R.

Rivera, Luis

Rodriguez, Maria

Rudolph, Cathy

Santiago, Maria

Severance, Scott

Shepherd, Ronald

Singer, Steven

Stevens, James

Sullivan, Bernard

Kelly

Alcon P.R.

MedChem U.S.A.

Alcon P.R.

MedChem U.S.A.

MedChem U.S.A.

MedChem U.S.A.

MedChem P.R.

MedChem U.S.A.

MedChem U.S.A.

P.R.

P.R.

Woburn

P.R.

Woburn

Woburn

Woburn

Woburn

Woburn

Woburn

Swann, David

MedChem P.R.

MedChem U.S.A.

Woburn

Woburn

Tanny, Jay

Velez, Nelson

MedChem P.R.

MedChem U.S.A.

Alcon P.R.

Woburn

Woburn

P.R.

Falvey, Paul

Ferdman, Ariel

Geffken, Daniel

Position

Period of

Affiliation

1

Manager quality systems

Director of manufacturing

1985-93

Vice president-mkt.& sales 2/28/90-9/26/91

Vice president–marketing

9/26/91-8/31/92

Avitene production manager

1992-95

Planner/buyer

1990-91

Director

9/1/89-8/31/92

President/chief oper. off. 9/1/89-8/31/92

Clerk

9/1/89-8/31/92

President

9/1/89-8/31/92

Secretary

9/1/89-4/12/91

Director

9/8/89-8/31/92

Assistant treasurer

12/1/89-8/31/92

Dir. of core technology

1988-94

Treasurer

12/1/89-5/29/91

Chief financial officer

2/28/90-5/29/91

Treasurer

9/1/89-5/29/91

Assistant secretary

9/1/89-4/12/91

Secretary

4/12/91-2/17/92

General plant manager

1981-94

1

Production supervisor

Treasurer

5/29/91-8/31/92

Secretary/clerk

2/27/92-8/31/92

Treasurer

2/27/92-8/31/92

1

Financial employee

General manager

2/29/88-6/29/90

Assistant treasurer

9/1/89-6/29/90

Planner/buyer

1992

Avitene prod. supervisor

1990-92

1

Quality assurance worker

Director quality assur.

1980-94

1

Vice president, operations

Dir. materials manager

1990-94

Assistant clerk

9/1/89-8/31/92

Assistant secretary/clerk

9/1/89-8/31/92

1

Dir. qlty. control/assur.

Vice president–operations

9/1/89-9/26/91

Sr. vice president-operat. 9/26/91-8/31/92

Director

9/1/89-2/28/92

Director/chairman

9/1/89-8/31/92

Chief executive officer

9/1/89-8/31/92

Director/chairman

9/1/89-8/31/92

1

Cost accountant

Planner/buyer

1991-92

1

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

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

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

- 7 product used to lubricate and separate tissues in ophthalmic

surgical procedures.

MedChem U.S.A. decided in 1987 to diversify

its operations by acquiring the Avitene business from Alcon P.R.,

which at the time was Avitene’s manufacturer and seller.

MedChem

U.S.A.’s decision was based in part on the fact that it was being

sued for patent infringement as to Amvisc.

The plaintiffs in

that lawsuit had commenced the lawsuit in 1984 and were seeking

an injunction and treble damages.

On December 18, 1987, petitioners entered into a series of

agreements with Alcon P.R., Alcon Pharmaceuticals, Ltd. (Alcon

Pharmaceuticals), and Alcon Laboratories, Inc. (Alcon Labs)

(these three Alcon entities are collectively referred to as the

Alcon Entities), to purchase the Avitene business for

approximately $31 million.

The agreements included three asset

purchase agreements, three noncompetition agreements, a guaranty,

and a processing agreement.

All of the Alcon Entities were

related, and none of the Alcon Entities was related to either

petitioner.

The assets sold under the asset purchase agreements

generally included all Avitene inventories, all tangible assets

used to manufacture Avitene, and all Avitene-related intangible

assets such as receivables, contract rights, and intellectual

property.

Under the first agreement, Alcon Labs sold to MedChem

U.S.A. receivables valued at $1,085,000, a non-competition

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

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

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

million and inventory valued at $2.5 million.

Under the second

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

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

million, various Food and Drug Administration (FDA) approvals

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

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

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

$5,000.

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

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

equipment valued at $800,000; the machinery and equipment had

been used by Alcon P.R. to manufacture Avitene and was located in

Alcon P.R.’s Avitene manufacturing facility in Humacao, Puerto

Rico (Humacao).

That facility consisted of the Avicon (Avitene)

plant, two unrelated plants, warehouse space, and administrative

offices.

Each of the asset purchase agreements required that the

Alcon Entities manufacture and sell to petitioners 20,000 pounds

of corium and provided that the Alcon Entities had to refund to

petitioners the entire amount paid for the Avitene business, plus

interest, if the corium could not be manufactured by December 31,

1990.

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

- 9 1992, Avitene was manufactured using the patents, know-how,

product specifications (as reflected in the FDA pre-market

approvals), and goodwill owned by MedChem U.S.A.

MedChem P.R.

held the legal title to all of the Avitene manufacturing

equipment, the raw materials used to manufacture Avitene, the

Avitene work-in-process, and the finished Avitene inventory until

sold.

When the finished Avitene was shipped from the Alcon P.R.

facility, title passed to the purchaser, which in all cases but

one was MedChem U.S.A.3

MedChem P.R. would invoice MedChem

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

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

From September 1, 1989, through August 31, 1992, MedChem U.S.A.

distributed, marketed, and sold Avitene from its offices in

Woburn.

MedChem P.R. played no part in these sales or in the

other sales of Avitene to end users.

The labels which MedChem

P.R. used during its fiscal year ended August 31, 1992,

3

The sole exception concerned the sale of Avitene for

distribution in Japan through June 6, 1991. In that case,

MedChem P.R. sold Avitene to Alcon Pharmaceuticals, which owned

the distribution rights to the Japanese market until June 6,

1991; title to that Avitene passed to Alcon Pharmaceuticals when

the finished Avitene was shipped from the Alcon P.R. facility.

Alcon Pharmaceuticals sold the distribution rights to the

Japanese market to MedChem U.S.A. on June 6, 1991, for $15

million, and MedChem U.S.A. transferred those rights to MedChem

P.R. on August 31, 1992. MedChem P.R.’s sales of Avitene for the

Japanese market accounted for approximately 20 percent of its

total net sales of Avitene.

- 10 designated Alcon P.R. as Avitene’s manufacturer.

The labels

read:

Manufactured by:

Alcon P.R.

Humacao, Puerto Rico 00661

For:

MedChem P.R.

Humacao, Puerto Rico 00661

Distributed by:

MedChem U.S.A.

Woburn, Massachusetts 01801

Neither petitioner acquired under the asset purchase

agreements Alcon P.R.’s Avitene-manufacturing facility in Humacao

or the right to market, distribute, or sell Avitene in Japan.4

That right to the Japanese market was initially retained by Alcon

Pharmaceuticals, which, during the period of retention, purchased

Avitene for the Japanese market from MedChem P.R.

Alcon P.R.

manufactured the Avitene sold to Alcon Pharmaceuticals and

treated it the same as all other Avitene for purposes of

scheduling, planning and buying, manufacturing, and quality

control.

The respective parties to the non-competition agreements

were:

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

Alcon Pharmaceuticals, and (3) MedChem U.S.A. and Alcon P.R.

Under these agreements, the Alcon Entities generally promised not

to manufacture, market, or sell any product having the same or

4

Neither petitioner has ever had an Avitene manufacturing

facility in Puerto Rico.

- 11 substantially the same form, function, or application as Avitene

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

MedChem U.S.A. gave the guaranty to each of the Alcon

Entities.

Under the guaranty, which was in effect throughout the

fiscal year ended August 31, 1992, MedChem U.S.A. guaranteed to

pay any debt and perform any obligation of MedChem P.R. arising

from the asset purchase and related agreements.

The processing agreement dealt primarily with a promise by

Alcon P.R. to manufacture Avitene for MedChem P.R. using Alcon

P.R.’s facility and labor and MedChem P.R.’s raw materials and

equipment.

(Alcon P.R. also used MedChem U.S.A.’s technology but

not pursuant to the processing agreement.)

See appendix B for

the relevant provisions of the processing agreement.

The

processing agreement expired initially on December 31, 1990, but

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

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

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

schedule, respectively.

From September 1, 1989, through August

31, 1992, Alcon P.R. manufactured Avitene for MedChem P.R.

pursuant to the processing agreement, and Alcon P.R. sent its

invoices for its manufacturing services directly to MedChem

U.S.A. for payment from the account of MedChem P.R.

Alcon P.R.

manufactured Avitene at its manufacturing facility in Humacao,

using its own personnel to manufacture, test, and package Avitene

- 12 and to supervise each of these functions.

Alcon P.R. was solely

responsible for resolving any problem that arose during the

period from the time that it received the corium up until the

time that the finished Avitene was delivered to a carrier for

delivery to MedChem U.S.A. (manufacturing process).

Alcon P.R. generally manufactured Avitene in accordance with

a two-phase process and kept its inventory of finished Avitene in

its warehouse attached to its manufacturing facility.

Avitene’s

two-phase manufacturing process was as follows:

Phase I

(1) Frozen corium and component materials were

ordered from the warehouse attached to the Avitene

manufacturing facility and transferred to a preparation

room in the facility, where the corium was thawed and

machine washed.

(2) The corium was machine cut into approximately

4 square inch pieces, manually inspected for

imperfections, and machine cut into smaller pieces of

approximately one square inch in size.

(3) The smaller pieces were acidified, washed with

alcohol, and tested against product specifications.

(4) The resulting product was refrigerated while

the initial steps were repeated for a second lot of

corium; the two lots were mixed together and dried in a

rotary dryer.

(5) The dried corium was machine milled into a

loose, powdery, fibrous substance known as bulk flour.

The bulk flour was placed in quarantined cages awaiting

further processing into its final form as either

finished flour or nonwoven web.

- 13 Phase II

(6) As to the manufacturing of nonwoven web, bulk

flour was transferred from the quarantined cage to the

web forming room, where it was machine processed into

rolls of nonwoven web.

(7) The rolls of nonwoven web were transferred to

the web cutting room where they were machine cut into

the required size, visually inspected against product

specifications, and placed in trays for drying and

sterilization. Once sterilized, the nonwoven web was

transferred to the pouch load and seal room where it

was packaged in a sealed pouch. The packaged nonwoven

web was sterilized, tested, and transferred to the

loading and shipping area.

(8) As to the manufacturing of finished flour,

jars were machine washed, loaded into trays and carts,

and dried in a walk-in oven.

(9) The jars were moved to the filling process

room where they were filled with bulk flour and placed

back into an oven for further drying.

(10) The dried jars (with bulk flour inside) were

transferred by carts to the capping room where they

were capped.

(11) The capped jars (with bulk flour inside) were

transferred by conveyor to the canning and sealing room

where they were canned, banded, and sealed with tamperproof material.

(12) The resulting jars (with bulk flour inside)

were moved to the sterilization room where they were

oven sterilized and transferred to the loading and

shipping area.

Petitioners entered into the processing agreement to ensure

a reliable supply of Avitene while they proceeded to establish

MedChem P.R.’s own Avitene manufacturing facility in Puerto Rico.

When the December 18, 1987, agreements were entered into,

petitioners intended to have that facility ready to take over the

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

original 3-year term.

In February 1988, Jonathan Donaldson traveled to Humacao and

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

At the

time, Mr. Perez was involved in and familiar with all aspects of

the Avitene manufacturing process; he was a longtime Alcon P.R.

employee with various supervisory responsibilities as to

Avitene’s manufacturing.

Shortly thereafter, while in Woburn,

Mr. Donaldson decided to hire Mr. Perez and communicated that

decision to Mr. Perez in Puerto Rico.

Mr. Perez accepted Mr.

Donaldson’s offer and worked for MedChem P.R. until June 30,

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

superior, Mr. Donaldson.

Mr. Perez worked from May 1988 through

June 30, 1990, primarily out of a one-room office (the only

office) that MedChem P.R. maintained in Humacao during that

period.

The office was equipped with three desks, a computer, a

facsimile machine, a photocopier, and file cabinets.

The office

contained product specifications, standard operating procedures,

invoices, and copies of some of the financial statements and

records which would be needed in the event of an audit.

MedChem P.R. paid Mr. Perez an annual salary, plus benefits,

to manage and coordinate its efforts in Puerto Rico as to the

5

This was one of the infrequent occasions on which Mr.

Donaldson or any of either petitioner’s other officers or

directors traveled to Puerto Rico on Avitene business.

- 15 manufacturing of Avitene.

From March 1988 through approximately

June 1988, Mr. Perez spent approximately 75 percent of his time

visiting Alcon P.R.’s Avitene manufacturing operation, making

sure that the operation was running smoothly and aiding the

anticipated transfer of that operation to MedChem P.R.

He spent

the remainder of his time during that period on MedChem P.R.’s

effort to establish its own Avitene manufacturing facility in

Puerto Rico.

During the remainder of his employment by MedChem

P.R., Mr. Perez spent approximately 70 percent of his time

working on MedChem P.R.’s proposed facility and the rest of his

time on Alcon P.R.’s Avitene manufacturing operation and the

daily operation of MedChem P.R.’s Humacao office.

Mr. Perez was the only employee that MedChem P.R. ever had

during the relevant years.

MedChem P.R. did hire three

independent contractors (Carlos Moya, Maria Pastrana, and Wanda

Rodriguez) to assist Mr. Perez in the Humacao office.

Ms.

Pastrana and Mr. Moya worked in the office during 1989, and Wanda

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

Mr. Moya was a materials coordinator, and Ms. Pastrana and her

successor, Ms. Rodriguez, were administrative secretaries.

MedChem P.R. directly paid these three individuals and issued to

them Forms 1099-MISC, Miscellaneous Income, reporting these

payments as nonemployee compensation.

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

Rico Industrial Development Co. for approximately 8.5 acres of

land in Juncos, Puerto Rico (Juncos), to be used as the site of

MedChem P.R.’s proposed manufacturing facility.

Conditions of

the sale included that MedChem P.R. would submit plans for

construction of an industrial building within 6 months, that

construction of the building would begin within 6 months of the

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

manufacturing operations for a minimum period of 10 years, that

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

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

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

commencement of the facility’s manufacturing operations and 120

people within 18 months thereafter.

Petitioners anticipated that

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

and, through January 31, 1990, MedChem P.R. made $885,216.56 of

capital expenditures relating to the facility’s proposed

construction.

Most of these expenditures concerned the services

of Unipro, an engineering and architectural firm retained by

MedChem P.R. to work on the proposed facility.

Unipro prepared

architectural drawings and designs for the facility.

In early 1990, MedChem U.S.A. suffered a devastating

financial blow from the Amvisc litigation.

On February 2, 1990,

the District Court hearing the case issued a preliminary

- 17 injunction barring MedChem U.S.A. from using, manufacturing, and

selling Amvisc in the United States.

MedChem U.S.A.’s only products.

Amvisc and Avitene were

MedChem U.S.A. faced the

possible payment of costly patent infringement damages, multiple

damages, and an award of attorney’s fees.

The Amvisc injunction

caused MedChem U.S.A. to default on $10 million in debt and to

lay off a third of its workforce.

The Amvisc injunction caused

petitioners to postpone indefinitely their plans to construct an

Avitene manufacturing facility in Puerto Rico.

Petitioners took several steps regarding Avitene in early

1990, following the Amvisc injunction.

First, in connection with

suspending their plans to construct the manufacturing facility in

Puerto Rico, they notified Unipro to stop its work on that

facility.

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

financial accounting and tax purposes all of the capitalized

expenditures ($881,966) relating to the proposed facility.

Third, MedChem P.R. closed its Humacao office and terminated the

workers there (Mr. Perez and Wanda Rodriguez).

In connection

therewith, Mr. Perez transferred to Alcon P.R. all of the records

as to suppliers and vendors which had been kept in the Humacao

office, and he transferred to MedChem U.S.A.’s Woburn facility

all of the other records which had been kept in the office,

including records relating to the design and construction of

MedChem P.R.’s proposed facility in Puerto Rico.

Fourth,

- 18 petitioners decided to move during the fall of 1990 the Avitene

manufacturing process (including the manufacturing equipment)

from Alcon P.R.’s Puerto Rico facility to MedChem U.S.A.’s idled

Amvisc facility in Woburn.6

Such a move would and did require

MedChem U.S.A. to make additional leasehold improvements in order

to conform the Amvisc facility to Avitene’s manufacturing

requirements.

Fifth, MedChem P.R. attempted to sell the land in

Juncos that it had purchased for the site of the proposed

facility.

Sixth, as of July 1, 1990, MedChem U.S.A. employees

wrote all of MedChem P.R.’s checks in Woburn and mailed those

checks from Woburn to the payees.

Petitioners moved the equipment used to process corium into

bulk flour into MedChem U.S.A.’s Woburn facility in June 1990.7

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

frozen corium and the equipment used to process bulk flour into

6

MedChem U.S.A. eventually constructed a bulk Avitene

manufacturing facility in Woburn in June 1992 and began producing

bulk Avitene there 4 months later. In July 1993, MedChem U.S.A.

began constructing an Avitene finished goods manufacturing

facility in Woburn; at that time, Alcon P.R. performed that part

of the Avitene manufacturing process at its facility in Puerto

Rico pursuant to the processing agreement. MedChem U.S.A.

substantially completed construction of the latter project in

April 1994, at which time MedChem U.S.A. controlled Avitene’s

entire manufacturing process.

7

At that time, the manufacturing of work-in-process was

completed and the machinery and equipment used in that process

disassembled and also readied for moving to Woburn.

- 19 nonwoven web.8

These two groups of equipment constituted all of

the manufacturing equipment necessary to perform the work in

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

of the manufacturing equipment related to phase 1 was located in

MedChem U.S.A.’s facility in Woburn.

By January 1, 1991,

petitioners had also transferred certain raw material

manufacturing functions into MedChem U.S.A.’s Woburn facility as

well.

The equipment used to perform the work in phase 2 of the

manufacturing process, i.e., processing bulk flour into finished

flour and finishing and packaging the nonwoven web, remained in

Alcon P.R.’s manufacturing facility in Humacao until early 1995

at which time it was shipped to the Woburn facility.

Alcon P.R.

continued in Puerto Rico until early 1995 to manufacture finished

Avitene from bulk flour and dry, sterilize, and package nonwoven

web under the terms of the processing agreement.

Alcon P.R. did

so using bulk flour and nonwoven web that had been manufactured

in Humacao during a buildup in 1989 and 1990; it did not use any

bulk flour or nonwoven web manufactured elsewhere.

When

petitioners moved the bulk and nonwoven web equipment to MedChem

U.S.A.’s facility in 1990, Alcon P.R. planned to use the part of

8

On separate occasions, MedChem U.S.A. reported to the

Securities and Exchange Commission (SEC) that, as of Nov. 30,

1990, and as of Feb. 28, 1991, respectively, MedChem U.S.A. was

in the process of redesigning its Amvisc manufacturing facility

in Woburn in order to start manufacturing Avitene there.

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

products.

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

employees to the manufacturing of Avitene before June 1990, and

it devoted 12 to 15 of its full-time production line employees

afterwards.

Alcon P.R. included the compensation paid to these

employees in the calculation of the processing fee charged to

MedChem P.R. under the processing agreement.

Of the 30 to 35

production line employees who worked on Avitene before June 1990,

approximately 15 to 20 worked in phase 1 of the manufacturing

process, and the remainder worked in phase 2.

The number of

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

after MedChem U.S.A. moved to Woburn the equipment used to

convert corium into bulk flour.

All of the production line employees were supervised by a

manager employed by Alcon P.R.; namely, Maria Rodriguez from

January 1990 to January 1, 1992, and Jimmy Carrion afterwards.

These managers reported to Ramon Alifonso, Alcon P.R.’s director

of manufacturing, who reported to Lee Hansen, Alcon P.R.’s

general manager for its manufacturing facility.

Alcon P.R. had a quality assurance department at its

manufacturing facility and employed in that department a director

and a staff of approximately 85 to 100.

The director, Maria

Santiago, reported to Alcon Labs’ quality assurance director in

- 21 Fort Worth, Texas.

Alcon P.R. was responsible for the quality of

Avitene, and its employees in its quality assurance department

performed each of the required tests as set forth in the product

specifications owned by MedChem U.S.A.

Alcon P.R. kept in its

quality assurance department all master documentation for the

manufacturing of Avitene and all related records such as

inspection documents, charts, and forms.

After Alcon P.R.

completed its quality assurance tests and document review, it

used its regular carrier to ship the packaged Avitene to MedChem

U.S.A. in Woburn, where MedChem U.S.A. stored the Avitene in a

warehouse or quarantine cage awaiting distribution to its

customers (i.e., the end users).

MedChem U.S.A. performed

secondary quality tests on the finished Avitene product at its

quality assurance department in Woburn.

MedChem P.R. did not

have a quality assurance department, and it never tested Avitene

for quality compliance.

MedChem U.S.A. prepared and filed all applications, reports,

and other documents required by the FDA to manufacture Avitene.

Alcon P.R. provided MedChem U.S.A. with information relating to

the manufacturing process, and MedChem U.S.A. incorporated that

information into its FDA filings.

MedChem P.R. did not submit

any applications, reports, or other documents to the FDA.

MedChem U.S.A.’s filings with the FDA for the period August 26,

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

- 22 manufacturer.

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

of 1989 and each of the relevant years thereafter that Alcon P.R.

was Avitene’s manufacturer and that Alcon P.R. manufactured

Avitene at its Puerto Rico facility for MedChem U.S.A.

MedChem P.R. did not have a facility registered with the FDA

to manufacture pharmaceuticals.

Alcon P.R.’s manufacturing

facility was so registered, and the FDA performed a yearlong

inspection of that facility beginning in August 1992.

During the

inspection, the FDA dealt almost exclusively with employees of

Alcon P.R.; contacts with non-Alcon P.R. personnel were minimal

and insignificant.

The FDA’s report on the inspection listed

Alcon P.R. as Avitene’s manufacturer.

MedChem U.S.A. had a department in Woburn where its

employees researched and developed Avitene.

During the subject

years, for example, MedChem U.S.A. researched and developed a new

form of Avitene named Endo-Avitene, which it began shipping in

November 1992.

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

research and development activities out of Woburn, and he was

assisted in his work by MedChem U.S.A. employees and/or Alcon

P.R. employees.

On a few occasions from 1990 through 1992, Dr.

Ferdman (occasionally accompanied by other MedChem U.S.A.

employees) traveled to Alcon P.R.’s manufacturing facility in

Puerto Rico to research and develop Avitene.

Dr. Ferdman’s

research and development work at Alcon P.R.’s manufacturing

- 23 facility related primarily to preparing validation studies to

obtain approval of an application that MedChem U.S.A. had made to

the FDA for Endo-Avitene.

Dr. Ferdman also worked at the Alcon

P.R. facility from April through August 1990 studying and

learning Avitene’s manufacturing process so that MedChem U.S.A.

could later in that year move that process into, and implement

that process in, MedChem U.S.A.’s Woburn facility.

MedChem P.R.

did not have a research and development function, and it played

no part in the development of new Avitene or the development of

other products.

Kelly provided temporary labor to Alcon P.R. at its

facilities from June 1990 through August 31, 1992, pursuant to

their written agreement stating in relevant part that the “Kelly

assigned employees, are the employees of Kelly, and none of said

persons assigned under this contract shall be regarded as

employees of [the buyers of the services]”.

Neither petitioner

was involved with that or any other agreement concerning

temporary labor to be provided at the Alcon P.R. facility.

As

relevant herein, Kelly charged Alcon P.R. $20.40 per hour for the

use of a Kelly employee and included in this rate the cost of

Kelly’s obligation to pay its employees’ workers’ compensation,

unemployment insurance, and Social Security taxes.

Kelly supplied Alcon P.R. with two of the three people who

worked at the Alcon P.R. facility from July 1990 through August

- 24 31, 1992, as the Avitene planner/buyer.9

The planner/buyer

generally established periodic schedules under which Alcon P.R.

manufactured Avitene for MedChem P.R. in accordance with orders

placed by MedChem U.S.A.

The planner/buyer also:

(1) Attended

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

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

used in the manufacturing process, (3) purchased materials and

components (exclusive of corium) through Alcon P.R.’s purchasing

system, after receiving the authorization of an Alcon P.R.

manager (and sometimes also a MedChem U.S.A. manager), (4) dealt

with Alcon P.R. or MedChem U.S.A. personnel to cure problems

arising mainly from the materials used in the Avitene

manufacturing process, and (5) verified with Alcon P.R. personnel

that the required quality assurance tests had been performed and

confirmed that the product was ready for shipping.

Raymond Castro was a Kelly employee who worked as

planner/buyer from on or about June 30, 1990, through March 1991.

Kelly hired him and paid him $12.02 per hour.

Neither petitioner

was involved in his hiring or in his placement as planner/buyer.

He reported to Ronald Shepherd and/or Luis Diaz, an Alcon P.R.

manager, and Mr. Castro’s work required that he interact with

Alcon P.R. employees and MedChem U.S.A. employees.

Alcon P.R.

invoiced MedChem P.R. for the amount that it paid Kelly as to Mr.

9

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

- 25 Castro, and MedChem P.R. accounted for its payment of these

invoices as an expense for outside services for office support.

Mr. Castro’s status as a Kelly employee ceased in March 1991,

when he was hired by Alcon P.R. as a full-time employee.

Mr.

Castro continued to work on Avitene matters after he was hired by

Alcon P.R., and he continued to interact with other Alcon P.R.

employees and with MedChem U.S.A. employees.

Nelson Velez succeeded Mr. Castro as planner/buyer from

March 1991 through April 1992.

Mr. Velez was a longtime Alcon

P.R. employee, and neither petitioner was involved in his

selection or placement as planner/buyer.

Mr. Diaz, who was Mr.

Velez’s superior, assigned Mr. Velez to serve concurrently as the

planner/buyer of both Avitene and an unrelated Alcon P.R.

product.

Mr. Velez divided his work equally between the two

functions, and Alcon P.R. invoiced MedChem P.R. for 50 percent of

his salary.

MedChem P.R. accounted for its payment of these

invoices as an expense for outside services for office support.

Mr. Castro’s Avitene-related work required that he interact with

Alcon P.R. employees and MedChem U.S.A. employees.

Luis Rivera was a Kelly employee who succeeded Mr. Velez as

planner/buyer from April 1992 to August 31, 1992.

him and paid him $12 per hour.

Kelly hired

Neither petitioner was involved

in his hiring or with his placement as planner/buyer.

Mr. Rivera

reported to Mr. Shepherd and/or various Alcon P.R. managers, and

- 26 Mr. Rivera’s work required that he interact with Alcon P.R.

employees and with MedChem U.S.A. employees.

Alcon P.R. invoiced

MedChem P.R. for the amount that it paid Kelly for Mr. Rivera’s

services, and MedChem P.R. accounted for its payment of these

invoices as an expense for outside services for office support.

Mr. Rivera’s status as a Kelly employee ceased on November 1,

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

consultant.

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

through 1993.

He was listed as a MedChem P.R. director on its

corporate records, but he never performed any duties as a MedChem

P.R. director.

He performed as a MedChem U.S.A. officer the

following ancillary activities relating to Avitene:

(1) He

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

requirements for Avitene for specified periods during the year,

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

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

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

assurance tests which were prepared by and received from Alcon

P.R., and (4) he monitored the sales of Avitene to customers.

He

did not attend the weekly manufacturing meetings held with Alcon

P.R. managers at Alcon P.R.’s facility.

MedChem P.R. maintained a checking account in Puerto Rico

through September 25, 1991.

MedChem P.R. used that account to

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

of its Humacao office.

On September 5, 1991, MedChem P.R. opened

a checking account in California (California account), listing as

its address MedChem U.S.A.’s address in Woburn.

Alcon P.R. sent

its invoices under the processing agreement to MedChem U.S.A.’s

Woburn address, and MedChem U.S.A.’s personnel reviewed those

invoices, authorized their payment, and paid them out of the

California account.

Vendors also sent their invoices for raw

materials and components, among other things, to MedChem U.S.A.’s

Woburn address where, after September 4, 1991, MedChem U.S.A.

personnel reviewed and paid those invoices out of the California

account.

Sean Moran and/or John McDonough signed the checks

payable to vendors drawn on the California account.

Mr. Moran,

who reported to Mr. Donaldson, spent approximately 30 percent of

his time on Avitene financial matters.10

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

elected under section 936(h)(5) to allocate between itself and

MedChem U.S.A. the Avitene-related costs, including the salary

expense of MedChem U.S.A. employees.

MedChem P.R.’s audited

financial statements for that year reported petitioners’

calculation of 50 percent of the total Avitene product line cost

of sales and selling, general, and administrative expenses.

10

Daniel Geffken also reported to Mr. Donaldson. Mr.

Geffken spent less than 50 percent of his time on Avitene-related

matters.

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

and selling, general, and administrative expenses (including the

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

matters) of $2,789,224 incurred by MedChem U.S.A. were charged to

MedChem P.R.

On its Federal income tax return for that year,

MedChem P.R. reported:

(1) Taxable income of $5,862,541 and (2)

direct labor costs of $323,000.

MedChem P.R. claimed a

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

Discussion

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

1992 Federal income tax liability by using the Puerto Rico and

possession tax credit (possession tax credit) provided under

section 936(a).

A domestic corporate taxpayer such as MedChem

P.R. qualifies for this credit if it meets the following

statutory requirements:

SEC. 936. PUERTO RICO AND POSSESSION TAX CREDIT.

(a) Allowance of Credit.-(1) In general.--Except as otherwise

provided in this section, if a domestic

corporation elects the application of this

section and if the conditions of both

subparagraph (A) and subparagraph (B) of

paragraph (2) are satisfied, there shall be

allowed as a credit against the tax imposed

by this chapter an amount equal to the

portion of the tax which is attributable to

the sum of-(A) the taxable income, from

sources without the United States,

from–

- 29 (i) the active

conduct of a trade or

business within a

possession of the United

States, or

(ii) the sale or

exchange of substantially

all of the assets used by

the taxpayer in the

active conduct of such

trade or business, and

(B) the qualified possession

source investment income.

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

are:

(A) 3-year period.--If 80

percent or more of the gross income

of such domestic corporation for

the 3-year period immediately

preceding the close of the taxable

year (or for such part of such

period immediately preceding the

close of such taxable year as may

be applicable) was derived from

sources within a possession of the

United States (determined without

regard to section 904(f)); and

(B) Trade or business.--If 75

percent or more of the gross income

of such domestic corporation for

such period or such part thereof

was derived from the active conduct

of a trade or business within a

possession of the United States.

Respondent determined and contends that none of MedChem

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

- 30 qualifies for the possession tax credit.11

Respondent argues

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

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

Petitioners contend that all of MedChem P.R.’s taxable income

qualifies for the possession tax credit.

Petitioners argue that

MedChem P.R. met the active conduct of a trade or business

requirement because, petitioners assert, all of MedChem P.R.’s

income was derived from its sales in Puerto Rico of Avitene that

it manufactured in Puerto Rico.

Petitioners assert that, in

addition to that sales income, MedChem P.R. had significant

business activities in Puerto Rico.

Petitioners assert that

MedChem P.R.’s business activities in Puerto Rico included

purchasing the raw materials necessary for Avitene, monitoring

manufacturing and inventory levels of Avitene, and owning all of

the manufacturing equipment, raw materials, work-in-process, and

finished goods related to Avitene.

Petitioners assert that

MedChem P.R. performed its business activities in Puerto Rico

through its common law employees consisting of its officers, the

Kelly employees, and employees who worked concurrently for

MedChem P.R. and either MedChem U.S.A. or Alcon P.R.

Petitioners

assert that MedChem P.R. also performed significant business

11

As an alternative to this determination, respondent

determined that MedChem P.R.’s income was taxable to the MedChem

Group under sec. 482(a). Because respondent does not pursue this

argument on brief, we consider it conceded.

- 31 activities in Puerto Rico through Alcon P.R., a contract

manufacturer.

Petitioners argue that activities performed

through a contract manufacturer such as Alcon P.R. are imputed to

the other party to the contract, in this case, MedChem P.R.

We agree with respondent that MedChem P.R. does not qualify

for the possession tax credit because it failed the active

conduct of a trade or business requirement of section

936(a)(2)(B).

As we read section 936(a), a domestic corporate

taxpayer may elect to determine its Federal income tax liability

by using the possession tax credit if it meets two requirements.

The credit equals the amount of tax attributable to the sum of

the taxpayer’s qualified possession-source investment income plus

the taxpayer’s non-U.S.-source income that it earned from:

(1)

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

(2) its sale or exchange of substantially all of the assets used

in the active conduct of that trade or business.

The two

requirements are the 80-percent test of section 936(a)(2)(A) and

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

We concern

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

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

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

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

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

- 32 from its active conduct of a trade or business within Puerto

Rico.

We are unable to find that such was the case.

MedChem P.R.

did not actively conduct a trade or business within Puerto Rico

throughout the 3-year period.

Whether MedChem P.R. actively

conducted such a trade or business is a highly fact intensive

issue as to which petitioners bear the burden of proof.

Cf.

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

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

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

210 (1st Cir. 1999).

Because Congress has not explicitly defined

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

of section 936(a) (or, for that matter, for any other purpose of

the Code), Congress has essentially left it to the Secretary to

define that phrase by way of regulations or, in the absence of

regulations, to the courts to construe the phrase by way of

judicial interpretation.

As the Supreme Court observed in

construing the phrase “trade or business” for purposes of section

162(a):

The phrase “trade or business” has been in §

162(a) and in that section’s predecessors for many

years. Indeed, the phrase is common in the Code, for

it appears in over 50 sections and 800 subsections and

in hundreds of places in proposed and final income tax

regulations. The slightly longer phrases, “carrying on

a trade or business” and “engaging in a trade or

business,” themselves are used no less than 60 times in

the Code. The concept thus has a well-known and almost

constant presence on our tax-law terrain. Despite

- 33 this, the Code has never contained a definition of the

words “trade or business” for general application, and

no regulation has been issued expounding its meaning

for all purposes. Neither has a broadly applicable

authoritative judicial definition emerged. Our task in

this case is to ascertain the meaning of the phrase as

it appears in the sections of the Code with which we

are here concerned. [Commissioner v. Groetzinger, 480

U.S. 23, 26 (1987); fn. refs. omitted.]

Given the lack of a statutory or regulatory definition of

the phrase “active conduct of a trade or business” as used in

section 936(a), we believe it appropriate to construe that phrase

by reference to the Secretary’s definitions of the phrase for

other purposes of the Code, bearing in mind Congress’ intent in

enacting section 936 as reflected in its legislative history.12

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

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

section 355 by reference to the definition set forth in the

regulations prescribed under section 355).

Our research reveals

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

22 times in the current version of the Internal Revenue Code13

and that the Secretary has issued extensive regulations

interpreting that phrase in three of those sections.

First, for

12

Of course, we also bear in mind the Supreme Court’s

interpretation of the phrase “trade or business” as espoused in

Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); to wit, an

activity in which a taxpayer is involved with continuity,

regularity, and a profit-motivated primary purpose.

13

See secs. 30A, 49, 168, 179, 351, 355, 367, 407, 543,

731, 806, 861, 865, 936, 954, 957, 995, 1202, 1298, 1362, 2057,

4001.

- 34 purposes of section 179, the Secretary prescribed in section

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

to the meaning of the phrase:

(6) Active conduct by the taxpayer of a trade

or business--(i) Trade or business. For purposes of

this section and § 1.179-4(a), the term “trade or

business” has the same meaning as in section 162 and

the regulations thereunder. * * *

(ii) Active conduct. For purposes of

this section, the determination of whether a trade or

business is actively conducted by the taxpayer is to be

made from all the facts and circumstances and is to be

applied in light of the purpose of the active conduct

requirement of section 179(b)(3)(A). In the context of

section 179, the purpose of the active conduct

requirement is to prevent a passive investor in a trade

or business from deducting section 179 expenses against

taxable income derived from that trade or business.

Consistent with this purpose, a taxpayer generally is

considered to actively conduct a trade or business if

the taxpayer meaningfully participates in the

management or operations of the trade or business. * *

* A mere passive investor in a trade or business does

not actively conduct the trade or business.

Second, for purposes of section 355, the Secretary

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

following relevant rules as to the phrase’s meaning:

(2) Active conduct of a trade or business

immediately after distribution--(i) In general. For

purposes of section 355(b), a corporation shall be

treated as engaged in the “active conduct of a trade or

business” immediately after the distribution if the

assets and activities of the corporation satisfy the

requirements and limitations described in paragraph

(b)(2)(ii), (iii), and (iv) of this section.

(ii) Trade or business. A corporation

shall be treated as engaged in a trade or business

immediately after the distribution if a specific group

of activities are being carried on by the corporation

- 35 for the purpose of earning income or profit, and the

activities included in such group include every

operation that forms a part of, or a step in, the

process of earning income or profit. Such group of

activities ordinarily must include the collection of

income and the payment of expenses.

(iii) Active conduct. For purposes of

section 355(b), the determination whether a trade or

business is actively conducted will be made from all of

the facts and circumstances. Generally, the

corporation is required itself to perform active and

substantial management and operational functions.

Generally, activities performed by the corporation

itself do not include activities performed by persons

outside the corporation, including independent

contractors. A corporation may satisfy the

requirements of this subdivision (iii) through the

activities that it performs itself, even though some of

its activities are performed by others. * * *

(iv) Limitations. The active conduct of

a trade or business does not include–

(A) The holding for investment

purposes of stock, securities, land, or other property,

or

(B) The ownership and operation

(including leasing) of real or personal property used

in a trade or business, unless the owner performs

significant services with respect to the operation and

management of the property.

Third, for purposes of section 367, the Secretary prescribed

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

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

phrase’s meaning:

(b) Active conduct of a trade or business outside

the United States--(1) In general. Property qualifies

for the exception provided by this section if it is

transferred to a foreign corporation for use in the

active conduct of a trade or business outside of the

United States. Therefore, to determine whether

- 36 property is subject to the exception provided by this

section, four factual determinations must be made:

(i) What is the trade or business of the

transferee;

(ii) Do the activities of the transferee

constitute the active conduct of that trade or

business;

(iii) Is the trade or business conducted

outside of the United States; and

(iv) Is the transferred property used or

held for use in the trade or business?

Rules concerning these four determinations are provided

in paragraph (b)(2), (3), (4), and (5) of this section.

(2) Trade or business. Whether the

activities of a foreign corporation constitute a trade

or business must be determined under all the facts and

circumstances. In general, a trade or business is a

specific unified group of activities that constitute

(or could constitute) an independent economic

enterprise carried on for profit. For example, the

activities of a foreign selling subsidiary could

constitute a trade or business if they could be

independently carried on for profit, even though the

subsidiary acts exclusively on behalf of, and has

operations fully integrated with, its parent

corporation. To constitute a trade or business, a

group of activities must ordinarily include every

operation which forms a part of, or a step in, a

process by which an enterprise may earn income or

profit. In this regard, one or more of such activities

may be carried on by independent contractors under the

direct control of the foreign corporation. (However,

see paragraph (b)(3) of this section.) The group of

activities must ordinarily include the collection of

income and the payment of expenses. If the activities

of a foreign corporation do not constitute a trade or

business, then the exception provided by this section

does not apply, regardless of the level of activities

carried on by the corporation. * * *

*

*

*

*

*

*

*

- 37 (3) Active conduct. Whether a trade or

business is actively conducted must be determined under

all the facts and circumstances. In general, a

corporation actively conducts a trade or business only

if the officers and employees of the corporation carry

out substantial managerial and operational activities.

A corporation may be engaged in the active conduct of a

trade or business even though incidental activities of

the trade or business are carried out on behalf of the

corporation by independent contractors. In determining

whether the officers and employees of the corporation

carry out substantial managerial and operational

activities, however, the activities of independent

contractors shall be disregarded. On the other hand,

the officers and employees of the corporation are

considered to include the officers and employees of

related entities who are made available to and

supervised on a day-to-day basis by, and whose salaries

are paid by (or reimbursed to the lending related

entity by), the transferee foreign corporation. * * *

The rule of this paragraph (b)(3) is illustrated by the

following example.

Example. X, a domestic corporation, and Y, a

foreign corporation not related to X, transfer property

to Z, a newly formed foreign corporation organized for

the purpose of combining the research activities of X

and Y. Z contracts all of its operational and research

activities to Y for an arm’s-length fee. Z’s

activities do not constitute the active conduct of a

trade or business.

(4) Outside of the United States. Whether a

foreign corporation conducts a trade or business

outside of the United States must be determined under

all the facts and circumstances. Generally, the

primary managerial and operational activities of the

trade or business must be conducted outside the United

States and immediately after the transfer the

transferred assets must be located outside the United

States. Thus, the exception provided by this section

would not apply to the transfer of the assets of a

domestic business to a foreign corporation if the

domestic business continued to operate in the United

States after the transfer. In such a case, the primary

operational activities of the business would continue

to be conducted in the United States. Moreover, the

transferred assets would be located in the United

- 38 States. However, it is not necessary that every item

of property transferred be used outside of the United

States. As long as the primary managerial and

operational activities of the trade or business are

conducted outside of the United States and

substantially all of the transferred assets are located

outside the United States, incidental items of

transferred property located in the United States may

be considered to have been transferred for use in the

active conduct of a trade or business outside of the

United States.

(5) Use in the trade or business. Whether

property is used or held for use in a trade or business

must be determined under all the facts and

circumstances. In general, property is used or held

for use in a foreign corporation’s trade or business if

it is-(i) Held for the principal purpose of

promoting the present conduct of the trade or business;

(ii) Acquired and held in the ordinary

course of the trade or business; or

(iii) Otherwise held in a direct

relationship to the trade or business. * * *

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

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

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

taxes on foreign-source income if it derived at least 80 percent

of its income from sources within a U.S. possession and satisfied

certain other requirements.

The requirements for exemption from

tax as a possession corporation were generally carried forward

into section 931 of the Internal Revenue Code of 1954.

Congress

promulgated section 931 and its predecessors to encourage

American businesses to invest in U.S. possessions.

See G.D.

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

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

(1996).

American companies operating in the possessions were

originally subjected to double taxation in the form of the

Federal corporate income tax and the taxes of the possessions.

See Tariff Act of 1913, ch. 16, sec. II, 38 Stat. 166; Revenue

Act of 1918, ch. 18, 40 Stat. 1057.

Congress perceived that this

double tax burden placed American businesses at a competitive

disadvantage when compared with their British and French

counterparts which were not subject to taxation upon the profits

they earned abroad unless paid back to the home company.

Congress enacted section 931 to remove that competitive

disadvantage.

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

1939-1 C.B. (Part 2) 168, 174.

In its original form, section 931

allowed a corporation to exclude its possession-source income if

it met an “80-percent source” test and a “50-percent active trade

or business" test.

Because of the exclusion, and because

dividends received by a domestic corporation from its wholly

owned possessions subsidiary were not eligible for the

intercorporate dividends received deductions under section

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

income not repatriated to the United States.

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

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

- 40 for a more efficient system exempting possessions corporations so

that the possessions would not lose a significant source of

capital.

See Coca-Cola Co. & Subs. v. Commissioner, supra at 22.

In place of the exemption mechanism contained in section 931,

Congress enacted section 936 to permit a U.S. corporation to

elect a tax credit to offset the U.S. tax on its possessions

income.

Thus, the current version of the investment incentive

takes the form of a tax credit rather than an exemption.

It is clear from the legislative record that Congress was

aware of the highly favorable tax benefits afforded U.S.

corporations operating in Puerto Rico.

It is equally clear that

Congress intended to retain and reaffirm such tax benefits by

enacting section 936.

The Senate Finance Committee and the House

Ways and Means Committee stated the following, in virtually

identical reports:

The special exemption provided (under sec. 931) in

conjunction with investment incentive programs

established by possessions of the United States,

especially the Commonwealth of Puerto Rico, have been

used as an inducement to U.S. corporate investment in

active trades and businesses in Puerto Rico and the

possessions. Under these investment programs little or

no tax is paid to the possessions for a period as long

as 10 to 15 years and no tax is paid to the United

States as long as no dividends are paid to the parent

corporation.

Because no current U.S. tax is imposed on the

earnings if they are not repatriated, the amount of

income which accumulates over the years from these

business activities can be substantial. The amounts

which may be allowed to accumulate are often beyond

what can be profitably invested within the possession

- 41 where the business is conducted. As a result,

corporations generally invest this income in other

possessions or in foreign countries either directly or

through possessions banks or other financial

institutions. In this way possessions corporations not

only avoid U.S. tax on their earnings from businesses

conducted in a possession, but also avoid U.S. tax on

the income obtained from reinvesting their business

earnings abroad.

The committee after studying the problem concluded

that it is inappropriate to disturb the existing

relationship between the possessions investment

incentives and the U.S. tax laws because of the

important role it is believed they play in keeping

investment in the possessions competitive with

investment in neighboring countries. The U.S.

Government imposes upon the possessions various

requirements, such as minimum wage requirements and

requirements to use U.S. flagships in transporting

goods between the United States and various

possessions, which substantially increase the labor,

transportation and other costs of establishing business

operations in Puerto Rico. Thus, without significant

local tax incentives that are not nullified by U.S.

taxes, the possessions would find it quite difficult to

attract investments by U.S. corporations.

However, investing the business earnings of these

possession corporations outside of the possession where

the business is being conducted does not contribute

significantly to the economy of that possession either

by creating new jobs or by providing capital to others

to build new plants and equipment. Accordingly, while

the committee believes it is appropriate to continue to

exempt trade or business income derived in a possession

and investment income earned in that possession, your

committee does not believe it is appropriate to provide

a tax exemption for income from investments outside of

the possession.

In addition, the committee recognizes that the

provision of present law denying a dividends received

deduction to the U.S. parent corporation forces a

possessions corporation to invest its income abroad

until the possessions corporation is liquidated

(usually upon the termination of the local tax

exemption) when it can be returned to the United States

- 42 tax free. These accumulated business profits are not

available for investment within the United States, and

the income produced is (under present law) not subject

to U.S. tax. The committee believes that while it is

appropriate to tax the foreign source investment income

from possession business earnings, possessions

corporations should at the same time be given the

alternative of returning the business income to the

United States prior to liquidation without paying U.S.

tax. Permitting tax-free repatriation of the

accumulated earnings only upon the liquidation of the

possessions corporation, while taxing the foreign

source investment derived from the accumulated

earnings, would lessen to a significant extent the tax

incentive of making the initial investment.

To accomplish these two major changes, the

committee’s amendment revises present law to provide

for a more efficient system for exemption of

possessions corporations. Under the amendment, these

corporations are generally to be taxed on worldwide

income in a manner similar to that applicable to any

other U.S. corporation, but a full 48 percent foreign

tax credit is to be given for the business and

qualified investment income from possessions regardless

of whether or not any tax is in fact paid to the

government of the possession. The effect of this

revised treatment will be to exempt from tax the income

from business activities and qualified investments in

the possessions, to allow a dividends received

deduction for dividends from a possessions corporation

to its U.S. parent corporation, and to tax currently

all other foreign source income of possessions

corporations (with allowance for the usual foreign tax

credit). The committee believes that this revised

treatment will assist the U.S. possessions in obtaining

employment-producing investments by U.S. corporations,

while at the same time encouraging those corporations

to bring back to the United States the earnings from

these investments to the extent they cannot be

reinvested productively in the possession. [S. Rept.

94-938, at 277-278 (1976), 1976-3 C.B. (Vol. 3) 57,

315-316; fn. refs. omitted.]

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

945, 946-947.

- 43 On the basis of our understanding of the legislative record,

we believe that Congress promulgated the “active conduct of a

trade or business” requirement of section 936(a) intending to

prevent a domestic corporate taxpayer from availing itself of the

possessions tax credit unless it established and regularly

operated an employment-producing, profit-motivated business

activity in a U.S. possession.

We also believe that Congress

expected the taxpayer to participate meaningfully in the

management and operation of that activity and to invest

significantly in that activity, the expected result of which

would be to strengthen the economy of the possession where the

activity was located.

In light of Congress’ intent for section

936, the Secretary’s interpretations of the subject phrase for

purposes of other sections of the Code, and the Supreme Court’s

interpretation of the phrase “trade or business” in section

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

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

possession only if it participates regularly, continually,

extensively, and actively in the management and operation of its

profit-motivated activity in that possession.

Cf. Commissioner

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

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

1968), affg. T.C. Memo. 1967-137.

We also believe that, for the

purpose of this participation requirement, the services

- 44 underlying a manufacturing contract may be imputed to a taxpayer

only to the extent that the performance of those services is

adequately supervised by the taxpayer’s own employees.

We ask ourselves in this case whether MedChem P.R.

participated regularly, continually, extensively, and actively in

the management and operation of Avitene’s manufacturing in Puerto

Rico throughout the requisite 3-year period.

Under the facts at

hand, we must answer that question in the negative.

Indeed, we

are not even able to find that MedChem P.R. had any meaningful

business activity in Puerto Rico during that period.

MedChem

P.R.’s investment in the economy of Puerto Rico during that

period was almost nonexistent in the sense that it placed in that

possession only one employee and established in that possession

only a one-room office.

Moreover, MedChem P.R. abandoned the

office and terminated the employee on June 30, 1990.

Although

MedChem P.R.’s decision to have Avitene manufactured in Puerto

Rico did result in the use of some of that possession’s work

force, and thus ostensibly harmonize with Congress’ intent for

the possessions tax credit to produce employment in that

possession, we are unable to find that more than a few if any of

the individuals who worked in Puerto Rico on Avitene-related

matters were hired as a result of the Avitene contract.

All the

same, we do not believe that the creation of jobs in Puerto Rico

- 45 is the sole criterion that a taxpayer must meet in order to be

entitled to the possession tax credit.

Petitioners observe correctly that MedChem P.R. was involved

with the Puerto Rico-based manufacturing business of Avitene by

virtue of the fact that it supplied the raw materials and

equipment necessary to manufacture the drug.

Such minimal

association with a trade or business, however, does not

constitute the active conduct of a trade or business in Puerto

Rico for purposes of section 936(a).

The mere fact that a

taxpayer owns property used in a trade or business is simply not

enough to characterize the taxpayer as an active conductor of

that trade or business.

The taxpayer in such a situation does

not meet the requirement as to a regular, continual, extensive,

and active participant in the management and operation of the

profit-motivated activity.

Nor, in fact, does such a taxpayer

subject itself to many of the economic risks and benefits of

business in general.

Here, MedChem P.R. lacked any operational or directional

control over the Avitene business.

All of the business

activities connected to Avitene were directed and controlled by

Alcon P.R., out of its Puerto Rico-based operation, and by

MedChem U.S.A., out of its Woburn-based facility.

In fact,

petitioners’ involvement in Puerto Rico during the 3-year period

failed even to qualify as a trade or business in Puerto Rico,

- 46 given that petitioners’ involvement in that possession focused

mainly on the Woburn-based efforts of MedChem U.S.A.’s personnel

to understand the Avitene manufacturing process and, after June

30, 1990, to move that process from Alcon P.R.’s facility in

Puerto Rico to MedChem U.S.A.’s facility in Woburn.

Whereas

petitioners initially planned to establish a manufacturing

facility in Puerto Rico during the relevant years and, to that

end, hired Mr. Perez, opened an office in Humacao, and purchased

land in Juncos, their plans changed in 1990.

In 1990,

petitioners scuttled their efforts to establish a facility in

Puerto Rico, wrote off the proposed facility’s capitalized costs,

closed the Humacao office, terminated Mr. Perez, and began moving

the Avitene manufacturing process into MedChem U.S.A.’s idled

Amvisc facility in Woburn.

Petitioners also caused Alcon P.R. to

move into that facility all of the equipment in Puerto Rico that

had been and was required to be used to perform the work in phase

1 of the Avitene manufacturing process.

Petitioners assert that all of MedChem P.R.’s income was

attributable to its sale in Puerto Rico of Avitene that was

manufactured in that possession and that MedChem P.R. had a

significant business presence in Puerto Rico.

14

We disagree.14

We distinguish Frank v. International Canadian Corp., 308

F.2d 520 (9th Cir. 1962), a case cited by petitioners to support

their assertion that MedChem P.R. actively conducted a trade or

business by virtue of its sales activity. The relevant holding

(continued...)

- 47 For purposes of section 936(a), MedChem P.R.’s “ business

presence” in Puerto Rico was insignificant in that it did not

contribute significantly to Puerto Rico’s economy either by

creating new jobs or by providing capital to others to build new

plants and equipment.

See S. Rept. 94-938, supra at 277-278,

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

1976-3 C.B. (Vol. 2) at 946-947.

All of MedChem P.R.’s business

activities after June 30, 1990, were based in Woburn, and

petitioners’ primary connection to Puerto Rico during that time

was to further its efforts to move the manufacturing of Avitene

to Woburn, where the nonmanufacturing, Avitene-related business

and ancillary activities (e.g., financial oversight, sales, and

product development) were performed by MedChem U.S.A. employees.

Petitioners rely on the fact that title to the non-Japanesemarket Avitene passed from MedChem P.R. to MedChem U.S.A. in

Puerto Rico.

We do not believe that this fact, standing alone,

leads to petitioners’ proffered conclusion that MedChem P.R.

actively conducted a trade or business in Puerto Rico throughout

the 3-year period.

Indeed, the facts of this case leads us to a

contrary conclusion.15

Avitene was manufactured in Puerto Rico

14

(...continued)

in Frank concerned whether the taxpayer actively conducted a

trade or business and did not concern where that trade or

business was located.

15

Petitioners rely in part on their assertion in brief that

(continued...)

- 48 at the Alcon P.R. facility, and Alcon P.R.’s employees performed

every task required in the manufacturing process, including the

supervision thereof.

Alcon P.R.’s employees performed those jobs

without the right or ability of either petitioner to manage,

direct, or control any part of the manufacturing process.

Alcon

P.R. employees also performed Avitene’s quality assurance

function, including the retention of Avitene’s master

documentation and manufacturing records.16

MedChem U.S.A.’s

employees distributed, marketed, and sold Avitene from Woburn,

and they did so without any interaction or involvement by MedChem

P.R.

MedChem U.S.A.’s employees worked out of Woburn improving

Avitene and developing new forms of Avitene.

MedChem U.S.A.’s

Woburn-based personnel maintained for petitioners the books and

records as to Avitene and received, reviewed, and processed

payment on any Avitene-related invoice received by petitioners.

MedChem U.S.A.’s personnel provided Alcon P.R. and the

planner/buyers with manufacturing schedules prepared in Woburn;

15

(...continued)

the parties have stipulated that “100 percent of MedChem P.R.’s

income was derived from its sales in Puerto Rico of Avitene that

was manufactured in Puerto Rico”. Actually, the stipulation

reads that “100 percent of MedChem P.R.’s reported income came

from the sale of Avitene that was manufactured in Puerto Rico.”

The stipulation does not say that MedChem P.R. sold the Avitene

in Puerto Rico.

16

Although MedChem U.S.A. occasionally performed limited

quality assurance tests on finished Avitene, MedChem P.R.

performed no quality testing at all.

- 49 the planner/buyers, who were employed at the Alcon P.R. facility

by Kelly or Alcon P.R., made sure that Alcon P.R.’s personnel had

the materials necessary to manufacture Avitene.

MedChem U.S.A.

owned all of the intangible assets used to manufacture Avitene

and, throughout the 3-year period, guaranteed to the Alcon

Entities that it would pay all debts and perform all obligations

of MedChem P.R. arising from the asset purchase and related

agreements.

Petitioners list in their brief 23 activities which, they

assert, demonstrate that MedChem P.R. actively conducted a trade

or business in Puerto Rico during the requisite 3-year period.

We disagree with this assertion.

Some of the activities listed

by petitioners preceded the 3-year period, and very few of the

other listed activities occurred continually throughout that

period.

The isolated activities which did occur during the

period do not support petitioners’ conclusion that MedChem P.R.

continued to conduct actively a trade or business in Puerto Rico.

The mere fact that MedChem P.R. owned the necessary raw materials

and manufacturing equipment and hired Alcon P.R. to use those

materials and equipment to manufacture Avitene in Puerto Rico is

not enough under the facts herein to conclude that MedChem P.R.

actively conducted a trade or business in Puerto Rico throughout

- 50 the 3-year period.17

While it is true that petitioners continued

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

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

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

business was not MedChem P.R.’s trade or business.

In fact,

petitioners have consistently reported in all but one instance

that Alcon P.R. was Avitene’s manufacturer.

That one instance is

here where, solely for the purpose of Federal income tax,

petitioners invite the Court to hold that MedChem P.R. was in

fact Avitene’s manufacturer.

We decline that invitation.

Petitioners argue that MedChem P.R. had employees who

performed Avitene-related services in Puerto Rico during the 3year period.

Petitioners assert that MedChem P.R. paid for the

Avitene-related services of these individuals and that the

individuals represented the interests of MedChem P.R. while

working on Avitene matters.

Petitioners assert that MedChem P.R.

directed and controlled the Avitene-related work of these

individuals and that no non-MedChem P.R. employee or entity had

the ability to direct or control that work.

Petitioners

generally identify these individuals as the MedChem P.R. officers

17

Contrary to petitioners’ request, we do not find that

MedChem P.R. employees purchased those raw materials or monitored

the production of Avitene or any of the inventory. As discussed

herein, employees of either Alcon P.R. or MedChem U.S.A.

generally performed all of the services connected to Avitene

during the 3-year period.

- 51 and/or directors, the Kelly employees, certain MedChem U.S.A.

employees, and a certain Alcon P.R. employee; petitioners assert

that individuals in the latter two categories worked concurrently

as employees of MedChem P.R. and either MedChem U.S.A. or Alcon

P.R.

Petitioners specifically identify these individuals as:

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

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

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

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

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

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

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

Tanny, and (6) various unnamed engineers.

We do not find that any of the listed individuals were

MedChem P.R. employees.

The presence of an employer-employee

relationship is a factual determination that rests on the

principles of common law.

See, e.g., Nationwide Mut. Ins. Co. v.

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

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

Professional & Executive Leasing, Inc. v. Commissioner, 89 T.C.

225, 232 (1987), affd. 862 F.2d 751 (9th Cir. 1988); Simpson v.

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

3121(d)(2).

Factors commonly considered by courts in determining

such a relationship are the:

(1) Right to control the details of

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

withholding of taxes, workers’ compensation, and unemployment

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

the relationship.

See Professional & Executive Leasing, Inc. v.

Commissioner, 862 F.2d at 753 (citing United States v. Silk, 331

U.S. 704, 714-716 (1947); Simpson v. Commissioner, supra at

984-985).

Although each factor is important, the test that is

usually considered fundamental is set out in the regulations.

Section 31.3401(c)-1(b), Employment Tax Regs., which generally

sets forth rules as to an employer’s obligation to withhold

Federal income taxes on the payment of wages, provides:

Generally the relationship of employer and employee

exists when the person for whom services are performed

has the right to control and direct the individual who

performs the services, not only as to the result to be

accomplished by the work but also as to the details and

means by which that result is accomplished. That is,

an employee is subject to the will and control of the

employer not only as to what shall be done but how it

shall be done. In this connection, it is not necessary

that the employer actually direct or control the manner

in which the services are performed; it is sufficient

if he has the right to do so. * * * In general, if an

individual is subject to the control or direction of

another merely as to the result to be accomplished by

the work and not as to the means and methods for

accomplishing the result, he is not an employee.

See also secs. 31.3121(d)-1(c)(1) and 31.3306(i)-1(b), Employment

Tax Regs., providing language virtually identical to sec.

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

Insurance Contributions Act and the Federal Unemployment Tax Act,

respectively.

- 53 Here, we find nothing in the record to persuade us that

MedChem P.R. had the right to direct or control any of the

purported MedChem P.R. employees in their performance of Avitenerelated services.

Although petitioners invite us to find that

MedChem P.R. directed and controlled the Avitene-related work of

these individuals by virtue of the fact that they interacted with

one or more individuals who served concurrently as an officer

and/or director of MedChem P.R. and MedChem U.S.A., the record

indicates to the contrary.

All of the individuals who worked on

an Avitene matter were directed and controlled by either Alcon

P.R. or MedChem U.S.A.

In fact, MedChem P.R. was expressly

prohibited by the processing agreement from taking a managerial

role in the manufacturing process.

Moreover, MedChem P.R. never

even directed or controlled any of its officers, except possibly

Mr. Perez up until July 1, 1990.

We also believe it most telling

that MedChem P.R. did not hold any of these individuals out or

report them as employees until the commencement of this

litigation, that each of these individuals was hired and directly

paid by MedChem U.S.A. or Alcon P.R., that MedChem P.R. never

paid employment taxes as to these individuals, that MedChem P.R.

never provided these individuals with workers’ compensation

insurance or employee benefits, and that all of these individuals

worked at the Alcon P.R. and MedChem U.S.A. facilities.

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

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

requirement of section 936(a)(2)(B).

In so holding, we note that

petitioners rely erroneously on Suzy’s Zoo v. Commissioner, 114

T.C. 1 (2000), for a contrary holding.

There, the taxpayer was a

corporation that sold greeting cards and other paper products

bearing copies of one or more of the taxpayer’s cartoon

characters.

The taxpayer’s employees developed the characters,

and the taxpayer transferred the characters to printing companies

to print the paper products in accordance with the taxpayer’s

specifications.

The printers used their own ink and paperstock,

and they held title to and bore the risk of loss of the supplies

and printed goods until the goods were sent back to the taxpayer

for its acceptance or rejection.

The printers could not sell any

images of the characters, and they could not sell any of the

taxpayer’s paper products.

The taxpayer argued that, for

purposes of section 263A, the printers produced the finished

goods, and it resold them.

We disagreed.

We held that the

taxpayer was the producer of the finished goods.

We noted that

the printing of the characters onto the paper products was

ministerial and that the critical step in the manufacturing of

the finished good was the drawing of the characters.

In contrast

with the situation there, where the thrust of the work as to the

finished product was performed by the taxpayer, the thrust of the

- 55 work here as to the manufacturing of Avitene was performed by

Alcon P.R.

The Avitene manufacturing process was not ministerial

but required specialized skill and expertise, unlike the

reproduction process in Suzy’s Zoo.

We have rejected all arguments not discussed herein as

without merit or irrelevant.

To reflect the foregoing,

Decisions will be entered

under Rule 155.

- 56 APPENDIX A

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

Dec. 18, 1987

Petitioners buy the Avitene business from

Alcon P.R., and Alcon P.R. agrees to (and

ultimately does) manufacture Avitene for

MedChem P.R. for the 3-year period ended Dec.

31, 1990.

Feb. 29, 1988

MedChem P.R. hires Mr. Perez and establishes

a one-room office in Humacao.

June 21, 1989

MedChem P.R. purchases land for the

construction of an Avitene manufacturing

facility in Puerto Rico.

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

Feb. 2, 1990

District Court issues preliminary injunction

as to MedChem U.S.A.’s manufacture and sale

of Amvisc. MedChem P.R. writes off

capitalized expenses relating to its proposed

facility in Puerto Rico. Unipro notified to

stop work on that facility.

Feb. 28, 1990

MedChem U.S.A. initiates plans to locate an

Avitene manufacturing facility into its idled

Amvisc facility in Woburn during the fall of

1990.

June 30, 1990

Petitioners move their bulk flour

manufacturing equipment from Humacao to

Woburn. Mr. Perez terminated, Humacao office

closed, and records shipped to Woburn. Kelly

hires Mr. Castro to replace Mr. Perez as

Avitene planner/buyer.

July 1, 1990

MedChem U.S.A. personnel in Woburn write all

MedChem P.R. checks and mail those checks to

the payees. MedChem U.S.A.’s personnel in

Woburn approve and pay from MedChem P.R. bank

account all invoices delivered to MedChem

P.R.

- 57 December 1990

Petitioners move their bulk nonwoven web

manufacturing equipment from Humacao to

Woburn.

March 1991

Mr. Castro becomes Alcon P.R. employee with

non-Avitene duties, and Alcon P.R. assigns

Mr. Velez to perform Mr. Castro’s former

duties.

April 1992

Kelly hires Mr. Rivera to replace Mr. Velez

as Avitene planner/buyer.

August 1992

FDA audits the Avitene manufacturing process

and deals almost exclusively with Alcon P.R.

personnel.

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

October 1992

MedChem U.S.A. starts manufacturing Avitene

in Woburn.

July 1993

MedChem U.S.A. begins constructing a new

Avitene finished goods manufacturing facility

in Woburn.

April 1994

MedChem U.S.A. substantially completes the

construction of that facility.

- 58 APPENDIX B

PROCESSING AGREEMENT

PROCESSING AGREEMENT dated as of December 18, 1987

by and between MEDCHEM PUERTO RICO, INC. (“MedChem

[P.R.]”), a Delaware corporation, and ALCON (PUERTO

RICO) INC. (“Alcon [P.R.]”), a Delaware corporation.

In consideration of the mutual covenants and

agreements contained in this Agreement, MedChem [P.R.]

and Alcon [P.R.] covenant and agree as follows:

1. Definitions. As used in this Agreement, the

following terms have the meanings set forth below:

1.1 Acceptance Tests -- chemical, physical

and performance tests conducted in accordance with the

analytical procedures described in * * * [a referenced

schedule], to be applied to Avitene in order to

determine whether Avitene conforms to the Product

Specifications.

*

*

*

*

*

*

*

1.4 Conversion Process -- the manufacturing

process by which raw materials are converted into the

finished Avitene product.

*

*

*

*

*

*

*

1.6 Delivery -- the delivery by Alcon [P.R.]

of Avitene processed under this Agreement.

1.7 Equipment –- the machinery and equipment

owned by MedChem [P.R.] and required for the processing

of Avitene.

1.8 Humacao Plant – Alcon[ P.R.]’s Avitene

processing facility in Humacao, Puerto Rico.

*

*

*

*

*

*

*

1.10 Order –- a writing from MedChem [P.R.]

authorizing or directing Alcon [P.R.] to process and

Deliver Avitene.

- 59 1.11 Product Specifications -– the

specifications for Avitene set forth * * * [in a

referenced schedule].

1.12 Proprietary Information -- all patents,

trademarks, trade secrets, copyrights, inventions,

designs, logos, and any other proprietary rights owned

by MedChem [P.R.] which relate to the production and

processing of Avitene.

1.13 Processing Fee and Option C Processing

Fee –- the fees paid by MedChem [P.R.] to Alcon [P.R.]

for each Order filled by Alcon [P.R.] pursuant to

Section 9.

*

2.

*

*

*

*

*

*

Processing.

2.1 In General. Subject to the provisions

of Section 5, and in return for a Processing Fee as

defined in Section 9, Alcon [P.R.] agrees to process

from raw materials owned and supplied by MedChem [P.R.]

all of MedChem[ P.R.]’s requirements of Avitene for

sale by MedChem [P.R.] to third parties. The raw

materials used in the Conversion Process as well as the

finished Avitene Product will remain the sole property

of MedChem [P.R.] throughout Alcon[ P.R.]’s physical

possession thereof. Alcon [P.R.] agrees to commit its

Humacao Plant for the processing of Avitene to satisfy

MedChem[ P.R.]’s requirements, subject to the

provisions of Section 5. In the event that MedChem[

P.R.]’s requirements of Avitene ever exceed the

capacity of the Humacao Plant as of the date hereof,

MedChem [P.R.] shall, at its expense, obtain such

additional Equipment as is necessary to increase

production capacity at the Humacao Plant, or shall use

reasonable efforts to obtain access elsewhere to

additional production capacity in order to meet the

requirements that the Humacao Plant is unable to

satisfy.

2.2 Specifications. Alcon [P.R.] agrees to

process Avitene in accordance with the Product

Specifications and Good Manufacturing Practices as

defined by applicable laws and regulations * * *.

- 60 2.3 Processing Method. To assist Alcon

[P.R.] in satisfying its obligations under this

Agreement, MedChem [P.R.] shall grant to Alcon [P.R.]

pursuant to the terms of Section 4 the right to use the

Equipment, without charge therefor. Alcon [P.R.] shall

furnish all labor, variable and fixed overhead and

quality assurance required for the processing of

Avitene hereunder. MedChem [P.R.] will employ a plant

manager and other appropriate personnel who will

inspect, advise and make corrections when appropriate

with respect to the Conversion Process; however,

MedChem [P.R.] employees will not participate in the

Alcon [P.R.] management process. Alcon [P.R.] shall be

responsible for all maintenance of the Equipment used

in the Conversion Process and for the compliance of

such Equipment with applicable regulations of

governmental agencies, including but not limited to

regulations promulgated by the U.S. Food and Drug

Administration and the Environmental Protection Agency;

the cost of such maintenance and compliance shall be

borne initially by Alcon [P.R.] but shall be included

in the Processing Cost (as such term is defined in

Section 9). Alcon [P.R.] shall also be responsible for

required validation studies on devices, formulae or

processes used in the Conversion Process. In the event

that Alcon [P.R.] is required by a regulatory authority

to perform additional validation studies for purposes

of validating new devices, new manufacturing procedures

and/or new raw material and finished product assay

procedures in order to continue lawfully to engage in

the processing of Avitene for MedChem [P.R.] (and

MedChem [P.R.], after notice from Alcon that such

additional validation studies are required, directs

Alcon [P.R.] to continue such processing), all expenses

borne by Alcon [P.R.] in the conduct of any such

validation studies shall be paid by Alcon [P.R.] and

shall be included in the Processing Cost. To the

extent that MedChem [P.R.] makes direct expenditures

(not described in the preceding sentence) with regard

to (a) the purchase of machinery or equipment, (b) the

compliance of existing machinery or equipment with all

applicable laws and regulations or (c) the performance

of validation studies or any matter relating to the

Conversion Process, such expenditures shall not be

included in the Processing Cost.

- 61 3.

License.

3.1 Grant. MedChem [P.R.] shall grant to

Alcon [P.R.] a royalty-free nonexclusive,

nontransferable license to use the Proprietary

Information solely in connection with the processing of

Avitene for MedChem [P.R.] pursuant to this Agreement.

3.2 Ownership. Title to, and ownership of,

the Proprietary Information shall at all times remain

solely and exclusively with MedChem [P.R.], and Alcon

[P.R.] shall not take any action inconsistent with such

title and ownership.

3.3 Protection. Alcon [P.R.] hereby

covenants to hold such Proprietary Information in

confidence. Alcon [P.R.] shall not, without the prior

written consent of MedChem [P.R.], disclose or

otherwise make available such Proprietary Information

in any form to any person, except to Alcon[ P.R.]’s

employees. * * *

3.4 Equitable Relief; Indemnification.

Since an unauthorized use or transfer of the

Proprietary Information will substantially diminish the

value to MedChem [P.R.] of its rights with respect

thereto, if Alcon [P.R.] breaches any of its

obligations under this Section 3, MedChem [P.R.] shall

(without limiting its other rights or remedies) be

entitled to equitable relief (including but not limited

to injunctive relief) to protect its interests. Alcon

[P.R.] shall indemnify and hold MedChem [P.R.] harmless

for any losses or damages which MedChem [P.R.] may

suffer as a result of any unauthorized use, transfer or

disclosure of the Proprietary Information caused by the

acts or omission of Alcon [P.R.].

4. Machinery and Equipment. For the duration of

this Agreement, MedChem [P.R.] shall grant to Alcon

[P.R.] the right to use, free of charge, all Equipment

owned by MedChem [P.R.] and required in the Conversion

Process, provided that Alcon [P.R.] shall use such

Equipment solely for the purpose of processing Avitene

pursuant to this Agreement. Title to and ownership of

the Equipment shall remain at all times solely and

exclusively with MedChem [P.R.]. Alcon[ P.R.]’s rights

with respect to the use of the Equipment shall be

nontransferable. Alcon [P.R.] shall take reasonable

- 62 precautions to preserve the physical condition of the

Equipment, and upon the termination of this Agreement

pursuant to Section 12, shall return the Equipment to

MedChem [P.R.] in good working order and in the same

condition (taking into account normal wear and tear) as

it was initially provided to Alcon [P.R.]. In the

event of any damage to the Equipment covered by

insurance maintained by MedChem [P.R.], MedChem [P.R.]

shall be obligated to apply any proceeds received in

respect of such insurance, and Alcon [P.R.] shall be

relieved from liability to the extent of such proceeds.

5.

Ordering Procedure.

5.1 Initial Annual Forecast. MedChem [P.R.]

shall be responsible for directing the quantity and

types of Avitene processed by Alcon [P.R.]. In that

regard, MedChem [P.R.] shall, within 60 days of the

date of this Agreement, deliver to Alcon [P.R.] an

annual forecast (the “Initial Forecast Amount”) of

MedChem[ P.R.]’s projected requirements for each

Avitene product for each calendar quarter or fraction

thereof during the period commencing on the date of

this Agreement and ending on December 31, 1988. * * *

5.2 Subsequent Annual Forecast. No later

than August 15, 1988 and 1989, MedChem [P.R.] shall

submit to Alcon [P.R.] its preliminary annual forecast

of its quarterly requirements of Avitene for the next

calendar year (the “Current Annual Forecast Amount”).

Such preliminary annual forecast shall be updated on

November 30, 1988 and 1989.

5.3 Annual Commitment. MedChem [P.R.] shall

order at least 80% of the Initial Forecast Amount or

the Current Annual Forecast Amount and Alcon [P.R.]

shall be required to process up to 250% of the Initial

Forecast Amount or the Current Annual Forecast Amount.

In this regard, Alcon [P.R.] shall be given a

reasonable amount of time to meet any increases over

the Initial Forecast Amount. Alcon [P.R.] agrees, upon

reasonable notice, to act in good faith to meet any

such increases. In addition, in connection with

MedChem[ P.R.]’s efforts to establish the MedChem

[P.R.] Plant pursuant to Section 13, Alcon [P.R.]

agrees, upon reasonable notice to use good faith

efforts to process such reasonable amounts in excess of

250% of the Current Annual Forecast Amount during the

- 63 ninety (90) day period prior to the effective

termination of this Agreement so that MedChem [P.R.]

may maintain sufficient inventory to continue normal

sales activity while it commences operation at the

MedChem [P.R.] Plant. * * *

5.4 Orders and Quarterly Updates. Within a

reasonable time after the date of this Agreement, and

at least 15 days prior to January 1, April 1, July 1

and October 1 of each year thereafter, MedChem [P.R.]

shall furnish to Alcon [P.R.] (i) a binding order for

Avitene to be processed and Delivered by Alcon [P.R.]

on a date of Delivery specified by MedChem [P.R.],

which will allow Alcon [P.R.] at least 30 days from the

date of receipt of such Order before such Delivery is

required, and (ii) a forecast of MedChem[ P.R.]’s

projected requirements of Avitene for the three

calendar months following the calendar quarter covered

by the relevant Order * * *. Alcon [P.R.] shall

Deliver the specified quantity and type of Avitene

within not more than seven days after the Delivery date

specified in the Order. It is understood and agreed

that in the event Alcon [P.R.] is unable or unwilling

through no fault of MedChem [P.R.] to process Avitene

ordered by MedChem [P.R.] in the amount forecast and/or

ordered, MedChem [P.R.] is free, without thereby

restricting any rights or remedies it may have against

Alcon [P.R.] as a result of such nonperformance

hereunder, to seek the contract services of third

parties to process the incremental quantities which

Alcon [P.R.] is unable or unwilling to provide.

5.5. Invoices. Alcon [P.R.] shall submit to

MedChem [P.R.] an invoice as soon as practicable after

delivery of Avitene to MedChem [P.R.]. Such invoice

shall specify the amount and type of Avitene Delivered

pursuant to the relevant Order, the date of shipment,

and the Processing Cost, and a calculation of the

Processing Fee allocable to the Order.

*

6.

*

*

*

*

*

*

Packaging and Labeling.

6.1 Design of Package. MedChem [P.R.] shall

be responsible for preparing and providing to Alcon

[P.R.] labeling copy and/or artwork, as appropriate,

for Avitene, and MedChem [P.R.] hereby warrants that

- 64 such labeling shall be, in content, in compliance with

all applicable governmental regulations. In

determining the labeling for Avitene, MedChem [P.R.]

shall have the right to use its corporate and/or trade

name(s) and its own trademark(s), and to determine the

general design and appearance of such labeling.

6.2 Packaging. Utilizing the labeling copy

and/or artwork provided by MedChem [P.R.], Alcon [P.R.]

shall be responsible initially for producing finished

labeling and/or materials, and attaching or

accompanying such labeling to or with Avitene. MedChem

[P.R.] shall have the option of changing the labeling

copy and/or artwork for Avitene packaging at any time,

upon 90 days prior written notice to Alcon [P.R.].

MedChem [P.R.] shall further have the option of

assuming responsibility at any time for producing the

finished labeling and packaging materials and

delivering such materials to Alcon [P.R.] for

association with Avitene, provided that Alcon [P.R.]

has received 90 days prior written notice of such a

change.

7.

Delivery; Storage.

7.1 Delivery. Alcon [P.R.] shall ship

Avitene ordered by MedChem [P.R.] to such

destination(s) as MedChem [P.R.] shall designate in its

Order. All Deliveries of Avitene under this Agreement

shall be F.O.B. common carrier designated by MedChem

[P.R.]. Any potential liability for loss or damage

that Alcon [P.R.] may maintain by reason of its

physical possession throughout the Conversion Process

of the raw materials and finished Avitene owned by

MedChem [P.R.] shall cease upon Delivery of such

Avitene to a common carrier. MedChem [P.R.] shall be

responsible for (i) the payment of all transportation

charges, taxes, and other charges incident to the

storage and movement of Avitene in commerce subsequent

to such transfer of the risk of loss to MedChem [P.R.],

and (ii) the cost of all insurance relating to the

Equipment, raw materials, inventory and the processing

and storage of such Avitene, and such costs and charges

shall not be included in the calculation of the

Processing Costs.

7.2

Storage; Related Documentation. At

MedChem[ P.R.]’s request and for so long as this

- 65 Agreement is in effect, Alcon [P.R.] shall make

available to MedChem [P.R.] adequate warehouse space at

the Humacao Plant for the storage of Avitene processed

pursuant to this Agreement or purchased by MedChem

[P.R.] pursuant to the Asset Purchase Agreement.

MedChem [P.R.] shall have the right to inspect such

warehouse space upon reasonable prior notice and during

normal business hours.

8.

[P.R.].

Acceptance and Rejection of Avitene by MedChem

8.1 In General. Except as set forth below,

MedChem [P.R.] shall have the right, within 30 working

days following actual receipt by MedChem [P.R.] of any

Delivery, to reject any Avitene so Delivered which does

not conform in any material respect with the Product

Specifications, provided that such nonconformity did

not result from contamination or other physical damage

cause by MedChem [P.R.] or third parties occurring

after Delivery (other than contamination caused by

subsequent Delivery by Alcon [P.R.] of contaminated

Avitene.) [sic] * * *

8.2 Changes in Conversion Process;

Alternative Suppliers. Upon written consent by MedChem

[P.R.], Alcon [P.R.] may alter the Conversion Process

or obtain Avitene from alternative suppliers for

Delivery to MedChem [P.R.]. * * *

8.3 Testing by Alcon [P.R.]. Alcon [P.R.]

shall submit to MedChem [P.R.], together with each

shipment, batch or lot of Avitene Delivered to MedChem

[P.R.] a written notice (i) certifying that such

shipment, batch or lot of Avitene meets in every

material respect the Product Specifications and (ii)

specifying the results of Alcon[ P.R.]’s analysis of

such shipment, batch or lot.

8.4 Testing by MedChem [P.R.]. MedChem

[P.R.], at its option, may perform the Acceptance Tests

on random sample packages of Avitene in order to

determine whether such Avitene conforms in every

material respect with the Product Specifications.

8.5 Notice; Return; Retesting; Replacement.

MedChem [P.R.] shall not be obligated to remit the

Processing Fee to Alcon [P.R.] for, and shall notify

- 66 Alcon [P.R.] in writing of, the failure of any sample,

shipment or lot of Avitene to meet in any material

respect the Product Specifications. MedChem [P.R.]

shall return to Alcon [P.R.] any such rejected sample,

shipment or lot of Avitene, at Alcon[ P.R.]’s expense.

Alcon [P.R.], at its expense, shall replace any

properly rejected sample, shipment or lot of Avitene.

Alcon [P.R.] shall also reimburse MedChem [P.R.] for

any inventory loss due to warehouse damage, damage

resulting from the failure of the Conversion Process

(except for damage resulting from changes in the

Conversion Process requested by MedChem [P.R.] and

instituted by Alcon [P.R.]) or the expiration of the

expiration date of any Avitene products stored by

MedChem [P.R.] in warehouse space provided by Alcon

[P.R.], provided that such expiration of the expiration

date is as a result of actions or omissions by Alcon

[P.R.] with respect to the management of the inventory.

Alcon [P.R.] will not be responsible for inventory

losses due to product obsolescence.

8.6 Product Recalls. If any Avitene product

is subjected to a recall by a governmental agency, or

in the event MedChem [P.R.], after notification to and

consultation with Alcon [P.R.], elects to make such a

recall based on MedChem[ P.R.]’s good faith belief that

such Avitene is defective or not in conformity with

Alcon[ P.R.]’s warranties, Alcon [P.R.] shall pay the

actual out-of-pocket costs in connection with such

recall, including without limitation the replacement of

recalled Avitene. The payment of such costs by Alcon

[P.R.] shall not be included in the computation of the

Processing Fee pursuant to Section 9 hereof. However,

if Alcon [P.R.] was not in breach of its warranties,

MedChem [P.R.] shall hold Alcon [P.R.] harmless and

shall bear all costs and expenses in connection with

such recall.

9.

Payment.

9.1 Processing Cost. In return for the

processing services performed by Alcon [P.R.] for

MedChem [P.R.], MedChem [P.R.] shall pay to Alcon

[P.R.] a Processing Fee in connection with each Order

for Avitene Delivered pursuant to this Agreement. The

Processing Fee shall be equal to Alcon[ P.R.]’s

Processing Cost (as such term is defined below) plus

ten percent (10%). However, the Processing Fee will be

- 67 adjusted at year end to account for manufacturing

variances, which shall be calculated pursuant to the

terms of this Section 9.

The Processing Fee shall be determined in two

steps. First, on or before December 31 of each year,

Alcon [P.R.] shall determine the estimated Processing

Cost for the coming year. Processing Costs shall be

composed of Standard Cost less the cost of raw

materials owned by MedChem [P.R.] and supplied to Alcon

[P.R.] for processing and the depreciation on machinery

and equipment owned by MedChem [P.R.] and used in the

Conversion Process. Standard Cost shall consist of the

sum of estimated direct labor, direct materials,

variable overhead, fixed overhead, and quality

assurance cost, and is defined in * * * [a referenced

schedule]. Standard Cost shall not include costs

associated with insurance provided by MedChem [P.R.],

freight or shipping costs which shall be separately

billed to MedChem [P.R.] by third parties. Standard

Cost also shall not include any direct labor costs

incurred by MedChem [P.R.] in connection with the

provision of services by MedChem [P.R.] employees at

the Humacao Plant. Such estimated Processing Cost plus

10% will then be used as the estimated Processing Fee

throughout the year for purposes of billing MedChem

[P.R.] for the quantity of Avitene produced each month.

Second, at the end of each year the parties shall

determine any manufacturing and/or processing variances

by comparing the Processing Cost for such year with the

actual cost and volumes of Avitene during such year.

If the variances indicate that the cost to Alcon [P.R.]

to process the Avitene was greater than the Processing

Cost, then MedChem [P.R.] shall pay to Alcon [P.R.] an

amount of money equal to the total amount of such

variance plus 10% within 30 days of MedChem[ P.R.]’s

receipt of written notice setting forth the amount of

such variance. If the variance indicates that the cost

to Alcon [P.R.] was less than the Processing Cost, then

MedChem [P.R.] shall receive from Alcon [P.R.] an

amount of money equal to the total amount of such

variance plus 10% within 30 days of the end of the

year. * * * MedChem [P.R.] shall have the right to

engage an independent auditor, upon reasonable written

notice, to examine the relevant books and records of

Alcon [P.R.] in order to confirm the accurate

calculation of Processing Cost.

- 68 9.2 Option C Processing Fee. In addition to

the Processing Fee payable pursuant to Section 9.1

above, MedChem [P.R.] shall pay to Alcon [P.R.] an

Option C Processing Fee in connection with the

processing of Corium to Option C Flour pursuant to this

Agreement. The Option C Processing Fee shall be

determined in two steps. First, on or before December

31 of each year, Alcon [P.R.] shall determine the

Option C Processing Cost of the Option C Flour. The

Option C Processing Cost shall be composed of the

Option C Standard Cost less the cost of raw materials

owned by MedChem [P.R.] and supplied to Alcon [P.R.]

for processing and the depreciation on machinery and

equipment owned by MedChem [P.R.] and used in the

Conversion Process. Option C Standard Cost shall

consist of direct labor, direct materials, variable

overhead, fixed overhead and quality assurance cost,

and is defined in * * * [a referenced schedule].

Option C Standard Cost shall not include costs

associated with insurance provided by MedChem [P.R.],

freight or other costs which shall be separately billed

to MedChem [P.R.] by third parties. Option C Standard

Cost also shall not include any direct labor costs

incurred by MedChem [P.R.] in connection with the

provision of services by MedChem [P.R.] employees at

the Humacao Plant. The Option C Processing Cost plus

10% will then be used throughout the year for the

purposes of billing MedChem [P.R.] for the quantity of

Option C Flour produced each month.

The second step in determining the Option C

Processing Fee shall take place at the end of each

year. At that time, Alcon [P.R.] shall determine any

manufacturing and/or processing variances by comparing

the Option C Processing Cost for such year with the

actual cost and volumes of Option C Flour during such

year. If the variances indicate that the cost to Alcon

[P.R.] to process the Option C Flour was greater than

the Option C Processing Cost, then MedChem [P.R.] shall

pay to Alcon [P.R.] an amount of money equal to the

total amount of such variance plus 10% within 30 days

of MedChem[ P.R.]’s receipt of written notice setting

forth the amount of such variance. If the variance

indicates that the cost to Alcon [P.R.] was less than

the Option C Processing Cost, then MedChem [P.R.] shall

receive from Alcon [P.R.] an amount of money equal to

the total amount of such variance plus 10% within 30

days of the end of the year. MedChem [P.R.] shall have

- 69 the right to engage an independent auditor, upon

reasonable written notice, to examine the relevant

books and records of Alcon [P.R.] in order to confirm

the accurate calculation of the Option C Processing

Cost.

10. Payment. MedChem [P.R.] shall pay Processing

Fees pursuant to Alcon[ P.R.]’s invoice for Avitene

Delivered under any Order within 30 days following

receipt by MedChem [P.R.] of such invoice. Payment by

MedChem [P.R.] of any invoice submitted by Alcon [P.R.]

to MedChem [P.R.] shall not be required with respect to

any shipment or lot of Avitene which has been properly

rejected and returned by MedChem [P.R.] in accordance

with Section 8.5. Payment of any disputed amount (but

only to the extent of the disputed amount) shall be

deferred until resolution of such dispute.

11.

Warranty.

11.1 General Warranty; Inspection. Alcon

[P.R.] warrants that any Avitene Delivered under this

Agreement shall meet the Product Specifications in

every material respect, and that at the time of

Delivery such Avitene shall be uncontaminated and free

from defects in materials and workmanship. MedChem

[P.R.] may make changes in the Product Specifications,

but such changes must be made known to and agreed to by

Alcon [P.R.], which agreement shall not be unreasonably

withheld or delayed, and Alcon [P.R.] shall promptly

incorporate said change(s) in such products, consistent

with Good Manufacturing Practices and regulatory

requirements. MedChem [P.R.] shall have the right to

inspect the Humacao Plant during mutually agreed upon

times when the processing of Avitene is in progress to

insure that Alcon[ P.R.]’s processing of Avitene is in

compliance with the Product Specifications. This right

of inspection granted to MedChem [P.R.] shall not be

deemed as granting to MedChem [P.R.] access to any

trade secrets retained by Alcon [P.R.] subsequent to

the closing of the transactions contemplated by the

Asset Purchase Agreements.

11.2 MedChem [P.R.] Indemnity. MedChem

[P.R.] will indemnify and hold Alcon [P.R.] harmless

from any and all claims, damages, costs and/or

expenses, including, but not limited to attorneys fees,

arising directly from (i) any change required by

- 70 MedChem [P.R.] in the Product Specifications or the

Conversion Process from the manner in which such

procedures were carried out by Alcon [P.R.] as of the

date of this Agreement, if such change is the proximate

cause of such claim, damages, costs or expenses, (ii)

the promotion, distribution, sale and/or internal use

by MedChem [P.R.] of Avitene processed by Alcon [P.R.]

hereunder unless at the time of Delivery such Avitene

did not meet the warranty set forth in Section 11.1

hereof and (iii) any breach by MedChem [P.R.] of its

warranties and obligations under this Agreement. Upon

the filing of any such claim or suit, Alcon [P.R.]

shall immediately notify MedChem [P.R.] thereof and

shall permit MedChem [P.R.], at its cost, to handle and

control such claim or suit provided, however, that

Alcon [P.R.] may, at its own expense, retain such

additional attorneys as it may deem necessary, which

attorneys will be permitted to reasonably observe

and/or participate in all aspects of (but not control)

the defense of such claims or suits. MedChem [P.R.]

shall have the right, after consultation with Alcon

[P.R.], to resolve and settle any such claims or suits.

This Indemnity shall not abrogate or in any way modify

the obligations of Alcon [P.R.] pursuant to the

representations and warranties contained in the Asset

Purchase Agreement.

11.3 Alcon [P.R.] Indemnity. Alcon [P.R.]

will indemnify and hold MedChem [P.R.] harmless from

and against any and all liability, damage, loss, cost,

or expense resulting from any third party claims made

or suits brought against MedChem [P.R.] which arise

from Alcon[ P.R.]’s breach of any provision of this

Agreement, including, but not limited to, claims of

product defect relating to Avitene which is not in

conformity with the warranty set forth in Section 11.1

hereof. Upon the filing of any such claim or suit,

MedChem [P.R.] shall immediately notify Alcon [P.R.]

thereof and shall permit Alcon [P.R.], at its cost, to

handle and control such claim or suit; provided,

however, that MedChem [P.R.] may, at its own expense,

retain such additional attorneys as it may deem

necessary, which attorneys will be permitted to

reasonably observe and/or participate in all aspects of

(but not control) the defense of such claims or suits.

Alcon [P.R.] shall have the right, after consultation

with MedChem [P.R.], to resolve and settle any such

claims or suits.

- 71 12.

Term and Termination.

12.1 Term of Agreement. The term of this

Agreement shall commence on the date hereof and shall

end on December 31, 1990 (unless sooner terminated

pursuant to this Section 12), and may be renewed on

terms and conditions mutually satisfactory to the

parties hereto.

12.2

Insolvency. * * *

12.3

Default.

(a) In General. Except as otherwise

provided in this Section 12, either party, at its

option, may terminate this Agreement upon the

occurrence of any breach by the other party, provided

however (i) that the nonbreaching party shall have

delivered to the breaching party a written notice

specifying such breach in reasonable detail, (ii) that

the breaching party shall not have cured such breach

within 60 days after receipt of the notice and (iii)

that the nonbreaching party must exercise its option to

terminate this Agreement within 60 days after the

expiration of the cure period.

(b) Failure to Deliver by Alcon [P.R.].

Subject to the provisions of Section 12.3(c) of this

Agreement, MedChem [P.R.] may terminate this Agreement

if Alcon [P.R.] fails to Deliver Avitene ordered by

MedChem [P.R.] under this Agreement, provided, however,

(i) that MedChem [P.R.] shall have delivered to Alcon

[P.R.] a written notice of such failure to Deliver,

(ii) that Alcon [P.R.] shall have failed to make

Delivery within 60 days after receipt of such written

notice and (iii) that MedChem [P.R.] must exercise its

option to terminate this Agreement within 60 days after

the expiration of the cure period. Alcon [P.R.]

acknowledges and agrees that if Alcon [P.R.] fails to

Deliver Avitene ordered by MedChem [P.R.] under this

Agreement, MedChem [P.R.] may make alternative

arrangements, at Alcon[ P.R.]’s expense, for the

processing of Avitene for the then remaining term of

this Agreement. However, Alcon [P.R.] shall not be

liable for any incidental or consequential damages

sustained by MedChem [P.R.] due to such failure to

deliver.

- 72 (c)

Force Majeure. * * *

12.4 Establishment of MedChem [P.R.] Plant.

MedChem [P.R.] may terminate this Agreement pursuant to

the provisions of Section 13.

12.5 Remedies Not Exclusive. In the event

of a breach of this Agreement, the rights of

termination provided in this Section 12 shall not be

exclusive of any remedies to which either party may be

entitled at law or in equity (as limited by the express

terms of this Agreement), provided, however, that such

other remedies shall not be subject to the time

limitations set forth in Sections 12.3(a) and (b).

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13. MedChem [P.R.] Plant. The parties

acknowledge and agree that, during the term of this

Agreement, MedChem [P.R.] will take steps designed to

establish alternative facilities (the “MedChem [P.R.]

Plant”) that will enable MedChem [P.R.] to undertake

the Conversion Process. In connection with the

establishment of the MedChem [P.R.] Plant, MedChem

[P.R.] shall bear the costs of removing the Equipment

from the Humacao Plant, including, but not limited to,

the costs of repairing any damage to the Humacao Plant

caused by such removal. Alcon [P.R.] covenants that it

will provide reasonable assistance to MedChem [P.R.] in

establishing the MedChem [P.R.] Plant, including

training of the Humacao Plant Manager and other

appropriate MedChem [P.R.] personnel in all aspects of

the Conversion Process. In this regard, appropriate

MedChem [P.R.] employees shall have the right, during

the term of this Agreement, to observe with regard to

the Conversion Process carried out by Alcon [P.R.] at

the Humacao Plant. However, such MedChem [P.R.]

employees will not participate in Alcon[ P.R.]’s

management process. In addition, upon the construction

of the MedChem [P.R.] Plant, Alcon [P.R.] will assist

with the validation of three initial Avitene production

batches of each Avitene product produced at the MedChem

[P.R.] Plant. When MedChem [P.R.] has successfully

established the necessary machinery, equipment and

quality control procedures, implemented the Conversion

Process at the MedChem [P.R.] Plant and, in the sole

opinion of MedChem [P.R.], conducted satisfactory

validation tests and received all applicable

- 73 governmental approvals relating to the operation of the

MedChem [P.R.] Plant, MedChem [P.R.] shall have the

right to terminate this Agreement prior to December 31,

1990 upon at least ninety (90) days prior written

notice to Alcon [P.R.].

*

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17. Applicable Law. The validity, performance

and construction of this Agreement shall be governed by

the laws of the Commonwealth of Massachusetts.

*

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19. Notices. Notices and other communications by

a party under this Agreement shall be in writing and

hand-delivered, deposited with an overnight carrier for

next day delivery, or deposited in the United States

mail as certified mail, return receipt requested,

postage prepaid, addressed to the parties as follows

(or to such other addresses as either party may

designate from time to time in writing):

If to Alcon [P.R.]:

Alcon Laboratories, Inc.

6201 South Freeway

Forth Worth, TX 76134

Attention: Henry Meadows

Vice President and Controller

Surgical Specialty Division

If to MedChem [P.R.]:

MedChem Puerto Rico, Inc.

43 Nagog Park

Acton, MA 01720

Attention: President

and shall be deemed given when received.

20. No Agency Relationship. Neither party shall

be deemed to be the agent of the other party for any

purpose. Alcon [P.R.] shall be deemed an independent

contractor for the purposes of its performance of

services for MedChem [P.R.]. * * *

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- 74 The parties hereto have executed this Agreement as

a sealed instrument and this Agreement becomes duly

effective, as of the date first written above.

MEDCHEM PUERTO RICO, INC.

By:

/s David A. Swann

Title: CEO

ALCON (PUERTO RICO) INC.

By:

/s

Title: Vice President