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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8778]

RIN 1545-AV67

Termination of Puerto Rico and Possession Tax Credit; New Lines

of Business Prohibited

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations that provide

guidance regarding the addition of a substantial new line of business

by a possessions corporation that is an existing credit claimant. These

temporary regulations reflect changes made by the Small Business Job

Protection Act of 1996. The text of these temporary regulations also

serves as the text of the proposed regulations set forth in the notice

of proposed rulemaking on this subject in the Proposed Rule section

published elsewhere in this issue of the Federal Register.

DATES: These regulations are effective September 18, 1998.

Applicability: These regulations apply to taxable years of a

possessions corporation beginning after August 19, 1998.

FOR FURTHER INFORMATION CONTACT: Patricia A. Bray or Elizabeth Beck,

(202) 622-3880, or Jacob Feldman, (202) 622-3830 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 1601(a) of the Small Business Job Protection Act of 1996,

Public Law 104-188, 110 Stat. 1755 (1996), amended the Internal Revenue

Code by adding section 936(j). Section 936(j) generally repeals the

Puerto Rico and possession tax credit for taxable years beginning after

December 31, 1995. However, the section provides grandfather rules

under which a corporation that is an existing credit claimant would be

eligible to claim credits for a transition period. The Puerto Rico and

possession tax credit will phase out for these existing credit

claimants ending with the last taxable year beginning before January 1,

2006.

For taxable years beginning after December 31, 1995 and before

January 1, 2006, the Puerto Rico and possession tax credit applies only

to a corporation that qualifies as an existing credit claimant (as

defined in section 936(j)(9)(A)). The determination of whether a

corporation is an existing credit claimant is made separately for each

possession. A possessions corporation that adds a substantial new line

of business (other than in a qualifying acquisition of all the assets

of a trade or business of an existing credit claimant) after October

13, 1995, ceases to be an existing credit claimant as of the beginning

of the taxable year during which such new line of business is added.

Therefore, a possessions corporation that ceases to be an existing

credit claimant either because it has added a substantial new line of

business, or because a new line of business becomes substantial, during

a taxable year may not claim the Puerto Rico and possessions tax credit

for that taxable year or any subsequent taxable year.

Explanation of Provisions

This document provides temporary regulations that interpret section

936(j)(9)(B). In particular, temporary regulation Sec. 1.936-11T adopts

principles similar to those in Sec. 1.7704-2(c) and (d) (transition

rules for existing publicly traded partnerships) for determining

whether a corporation has added a substantial new line of business.

Paragraph (a) of Sec. 1.936-11T states the general rule that, if a

possessions corporation that is an existing credit claimant, as defined

in section 936(j)(9)(A), adds a substantial new line of business during

a taxable year, it will cease to be an existing credit claimant as of

the close of the taxable year ending before the date of such addition.

The paragraph also generally describes the subjects discussed in the

other paragraphs in Sec. 1.936-11T.

Paragraph (b) addresses the meaning of the term new line of

business. The temporary regulation generally follows the approach of

Sec. 1.7704-2(d)(1), providing the general rule derived from

Sec. 1.7704-2(d)(2) that explains when a business activity is a pre-

existing business, and from Sec. 1.7704-2(d)(3) that defines when that

activity is closely related to a pre-existing business. Paragraph

(b)(1) provides that a new line of business is any activity of the

possessions corporation that is not closely related to a pre-existing

business of the possessions corporation.

Paragraph (b)(2) explains that, except as provided in paragraph

(b)(2)(ii), all the facts and circumstances (including factors A

through H in paragraph (b)(2)(i)) must be considered to determine

whether a new activity is closely related to a pre-existing business of

the possessions corporation. Paragraph (b)(2)(i) applies the same eight

factors considered in Sec. 1.7704-2(d)(3), except that the temporary

regulation provides that in applying factor H, the possessions

corporation may use either the new North American Industry

Classification System Code (NAICS code) or the Standard Industrial

Classification Code (SIC code).

Factor (H) is whether the United States Bureau of the Census

assigns the activity the same six-digit NAICS code (or four-digit SIC

code) as the pre-existing business. In the case of a pre-existing

business or activity that is listed under a NAICS code of 99999,

Unclassified establishments, or under a miscellaneous category (most

NAICS codes ending in a ``9'' are miscellaneous categories), the

similarity in NAICS codes is ignored as a factor in determining whether

the activity is closely related to the pre-existing business. The

dissimilarity of the NAICS codes is considered in determining whether

the activity is closely related to the pre-existing business. For

purposes of this section, NAICS codes must be set forth in the North

American Industry Classification System Manual, United States, that is

in effect for the taxable year during which a new line of business is

added.

Similarly, in the case of a pre-existing business or activity that

is listed under a SIC code of 9999, Nonclassifiable Establishments, or

under a miscellaneous category (most SIC codes ending in a ``9'' are

miscellaneous categories), the similarity in SIC codes is ignored as a

factor in determining whether the activity is closely related to the

pre-existing business. The dissimilarity of the SIC codes is considered

as a factor in determining whether the activity is closely related to

the pre-existing business. The SIC codes are set forth in the Executive

Office of the President, Office of Management and Budget, Standard

Industrial Classification Manual, that is in effect for the taxable

year during which a new line of business is added.

Paragraph (b)(2)(ii) provides safe harbors for determining whether

an activity is closely related to a pre-existing business in three

cases. First, an activity will be closely related to a pre-existing

business if the activity is within the same six-digit NAICS code or

four-digit SIC code as the pre-existing

[[Page 44388]]

business. Second, an activity will be closely related to a pre-existing

business if the activity is within the same five-digit NAICS code or

three-digit SIC code as the pre-existing business and the facts related

to the new activity satisfy at least three of the factors in paragraphs

(b)(2)(i)(A) through (G) of this section. Third, an activity will be

closely related to a pre-existing business if the pre-existing business

is making a component product or end-product form, as defined in

Sec. 1.936-5(a)(1), Q & A1, and the new activity is making an

integrated product (or end-product form with fewer excluded

components), that is not within the same six-digit NAICS code (or four-

digit SIC code) as the pre-existing business solely because the

component product and the integrated product (or the two end-product

forms) have different end-uses.

Paragraph (b)(3) provides that a business activity of a possessions

corporation is considered to be a pre-existing business if the

possessions corporation was actively engaged in the activity within the

possession on or before October 13, 1995, and the possessions

corporation elected the benefits of the Puerto Rico and possession tax

credit pursuant to an election which was in effect for the taxable year

that included October 13, 1995.

Paragraph (b)(3)(ii) explains how the acquisition of all of the

assets or the stock of an existing credit claimant can affect the

determination of whether an activity is a pre-existing business. It is

intended that an activity that is a pre-existing business of an

existing credit claimant and that continues to be carried on in the

possession by any affiliated or non-affiliated existing credit claimant

should continue to be characterized as a pre-existing activity since

all the assets and activity remain in the possession and no new

activity is introduced there. A non-affiliated acquiring corporation

will not be bound by any section 936(h) election made by the

predecessor existing credit claimant with respect to that business

activity.

Where all of the assets related to a pre-existing activity of an

existing credit claimant are acquired by a corporation that is not an

existing credit claimant, but that continues the activity in the

possession, the regulation provides that if the acquiring corporation

makes an election under section 936(e) for the taxable year of the

acquisition, the acquired activity will be treated as a pre-existing

activity of the acquiring corporation, and the acquiring corporation

will be treated as an existing credit claimant. The acquiring

corporation will be deemed to satisfy the rules of section 936(a)(2)

for the year of acquisition.

In the case of an acquisition of all the assets of a non-affiliated

existing credit claimant, the acquiring corporation will not be bound

by its predecessor's elections under sections 936(a)(4) and (h)

regarding that business activity.

A mere change in the ownership of a possessions corporation will

not affect its status as an existing credit claimant for purposes of

determining whether an activity is closely related to a pre-existing

business.

Paragraph (b)(4) provides that the test for a new line of business

is only applied at the time the new activity is added (as opposed to

the test of whether a new line of business is substantial, which is

applied annually under paragraph (c) of this section).

Paragraph (c)(1) provides the general rule for determining when a

new line of business becomes substantial. The paragraph explains that,

for purposes of section 936 and section 30A, a new line of business of

a possessions corporation is treated as substantial in the first

taxable year in which it satisfies either of the following two tests:

(1) The possessions corporation derives more than 15 percent of its

gross income for the taxable year from that line of business (the gross

income test); or (2) the possessions corporation directly uses in that

line of business more than 15 percent of its total assets (the assets

test). This position generally reflects the rules of Sec. 1.7704-

2(c)(1).

For purposes of the gross income test, paragraph (c)(2) provides

that the denominator is the amount that is the gross income of the

possessions corporation for the current taxable year, while the

numerator is the gross income of the new line of business for the

current taxable year. The gross income test must be applied at the end

of each taxable year. The income is not to be annualized when a new

activity begins late in the taxable year. Testing should occur on a

company-by-company basis, if a consolidated group election was made

pursuant to section 936(i)(5). In the case of a new line of business

acquired through the purchase of all of the assets of an existing

credit claimant, the gross income test for the acquiring corporation

for the year of the acquisition includes only the income from the date

of acquisition through the end of the taxable year that includes the

date of acquisition.

Paragraph (c)(3) provides rules for applying the annual assets

test. For purposes of the assets test, paragraph (c)(3) provides that

the denominator is the adjusted tax bases of the total assets of the

possessions corporation for the current taxable year, while the

numerator is the adjusted tax bases of the total assets utilized in the

new line of business for the current taxable year. Total assets include

intangibles, cash and receivables. In order to provide for

administrative convenience for both the taxpayer and the IRS and for

greater certainty in the result, the test uses the adjusted tax bases

of the applicable assets since these amounts are already reflected in

the books and records of the possessions corporation.

Paragraph (c)(3)(ii) permits an exception to the assets test. A new

line of business of a possessions corporation will not be treated as

substantial as a result of the assets test if an event that is not

reasonably anticipated causes the adjusted tax bases of the assets used

in the new line of business to exceed 15 percent of the adjusted tax

basis of the possessions corporation's total assets. An event that is

not reasonably anticipated would include the destruction of plant and

equipment of the pre-existing business due to a hurricane or other

natural disaster or other similar circumstances beyond the control of

the possessions corporation. The expiration of a patent is not such an

event and thus will not trigger this exception.

Paragraph (d) contains five examples that illustrate the rules of

this temporary regulation.

Paragraph (e) provides that a possessions corporation that adds a

significant new line of business during a taxable year may not claim

the Puerto Rico and possession tax credit on its return for the taxable

year in which the substantial new line of business is added or a new

line of business becomes substantial.

Paragraph (f) provides that the temporary regulation will apply to

taxable years of the possessions corporation beginning after August 19,

1998. However, taxpayers may elect to apply all of the provisions of

the regulation for any open taxable years beginning after December 31,

1995. Once an election is made, the regulation will apply for all

subsequent taxable years. The temporary regulations will not apply to

the activities of pre-existing businesses for taxable years beginning

before January 1, 1996.

Special Analyses

It has been determined that this temporary regulation is not a

significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required. It also has been

determined that section 553(b) of the Administrative Procedure Act (5

U.S.C. chapter 5) does not apply

[[Page 44389]]

to these regulations, and because the regulation does not impose a

collection of information on small entities, the Regulatory Flexibility

Act (5 U.S.C. chapter 6) does not apply. Moreover, the rules contained

in this Treasury decision provide taxpayers with immediate guidance

necessary to comply with section 936(j)(9)(B), which was effective for

taxable years beginning after December 31, 1995. In the absence of

temporary regulations, the only guidance regarding what is a new line

of business is a reference in the legislative history to the principles

of Sec. 1.7704-2(d) of the regulations. The only guidance regarding

what is substantial is a reference to Sec. 1.7704-2(c) in the Joint

Committee Explanation (Blue Book) of Public Law 104-188. Although a

possessions corporation might be able to construct a tax return

position based on this information, the effect of misinterpretation is

severe-- disqualification as an existing credit claimant, without

benefits for either the substantial new line of business or the pre-

existing business. Taxpayers must have unambiguous guidance on which

they can immediately rely in structuring their possession corporation

business activities. For these reasons this temporary regulation is

needed to ensure the efficient administration of the tax laws. Pursuant

to section 7805(f) of the Internal Revenue Code, this temporary

regulation will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on its effect on small

business.

Drafting Information. The principal author of these regulations is

Patricia A. Bray of the Office of the Associate Chief Counsel

(International), within the office of Chief Counsel, IRS. However,

other personnel from the IRS and the Department of the Treasury

participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

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

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

Par. 2. Section 1.936-11T is added to read as follows:

Sec. 1.936-11T New lines of business prohibited (temporary).

(a) In general. A possessions corporation that is an existing

credit claimant, as defined in section 936(j)(9)(A), and that adds a

substantial new line of business during a taxable year, or that has a

new line of business that becomes substantial during the taxable year,

will cease to be an existing credit claimant as of the close of the

taxable year ending before either such taxable year. The term new line

of business is defined in paragraph (b) of this section. The term

substantial is defined in paragraph (c) of this section. Paragraph (d)

of this section provides examples illustrating the rules of paragraphs

(a) through (c) of this section. Paragraph (e) of this section

instructs a possessions corporation not to claim the Puerto Rico and

possession tax credit on its return if it has added a substantial new

line of business during the taxable year. Paragraph (f) of this section

is the effective date provision.

(b) New line of business--(1) In general. A new line of business is

any business activity of the possessions corporation that is not

closely related to a pre-existing business of the possessions

corporation. The term closely related is defined in paragraph (b)(2) of

this section. The term pre-existing business is defined in paragraph

(b)(3) of this section.

(2) Closely related. All the facts and circumstances must be

considered, including paragraphs (b)(2)(i)(A) through (H) of this

section, to determine whether a new activity is closely related to a

pre-existing business of the possessions corporation, and thus is not a

new line of business.

(i) Factors. The following factors will help to establish that a

new activity is closely related to a pre-existing business activity of

the possessions corporation--

(A) The activity provides products or services very similar to the

products or services provided by the pre-existing business;

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

customers as that of the pre-existing business;

(C) The activity is of a type that is normally conducted in the

same business location as the pre-existing business;

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

those used in the pre-existing business;

(E) The activity's economic success depends on the success of the

pre-existing business;

(F) The activity is of a type that would normally be treated as a

unit with the pre-existing business in the business' accounting

records;

(G) If the activity and the pre-existing business are regulated or

licensed, they are regulated or licensed by the same or similar

governmental authority; and

(H) The United States Bureau of the Census assigns the activity the

same six-digit North American Industry Classification System (NAICS)

code or four-digit Industry Number Standard Identification code (SIC

code) as the pre-existing business. In the case of a pre-existing

business or activity that is listed under a NAICS code of 99999,

Unclassified Establishments, or under a miscellaneous category (most

NAICS codes that end in a ``9'' are miscellaneous categories), the

similarity in NAICS codes is ignored as a factor in determining whether

the activity is closely related to the pre-existing business. The

dissimilarity of the NAICS code is considered in determining whether

the activity is closely related to the pre-existing business. For

purposes of this section, NAICS codes must be set forth in the North

American Industry Classification System (United States) Manual that is

in effect for the taxable year during which a new line of business is

added. The official NAICS-United States Manual is available in both

printed and electronic versions from the National Technical Information

Service (NTIS) at 1-800-553-6847 or at the NTIS NAICS web site at

http://www.ntis.gov/naics>. In the case of a pre-existing business or

activity that is listed under a SIC code of 9999, Nonclassifiable

Establishments, or under a miscellaneous category (most SIC codes

ending in ``9'' are miscellaneous categories), the similarity in SIC

codes is ignored as a factor in determining whether the activity is

closely related to the pre-existing business. The dissimilarity of the

SIC codes is considered in determining whether the activity is closely

related to the pre-existing business. The SIC codes are set forth in

the Executive Office of the President, Office of Management and Budget,

Standard Industrial Classification Manual, that is in effect for the

taxable year during which a new line of business is added. A printed

version of the official SIC Manual is available from the National

Technical Information Service (NTIS) at 1-800-553-6847.

(ii) Safe harbors. An activity is closely related to a pre-existing

business and thus is not a new line of business in the following three

cases--

(A) If the activity is within the same six-digit NAICS code (or

four-digit SIC code);

[[Page 44390]]

(B) If both the pre-existing business activity and the new activity

are within the same five-digit NAICS code (or three-digit SIC code) and

the facts relating to the new activity satisfy at least three of the

factors listed in paragraph (b)(2)(i) (A) through (G) of this section;

or

(C) If the pre-existing business is making a component product or

end-product form, as defined in Sec. 1.936-5(a)(1), Q & A1, and the new

business activity is making an integrated product, or an end-product

form with fewer excluded components, that is not within the same six-

digit NAICS code (or four-digit SIC code) as the pre-existing business

solely because the component product and the integrated product (or two

end-product forms) have different end-uses.

(3) Pre-existing business--(i) In general. Except as provided in

paragraph (b)(3) (ii) and (4) of this section, a business activity is a

pre-existing business of the existing credit claimant if--

(A) The existing credit claimant was actively engaged in the

activity within the possession on or before October 13, 1995; and

(B) The existing credit claimant has elected the benefits of the

Puerto Rico and possession tax credit pursuant to an election which is

in effect for the taxable year that includes October 13,

1995.

(ii) Acquisition of all of the assets or stock of an existing

credit claimant. (A) If all the assets of a pre-existing business of an

existing credit claimant are acquired by an affiliated or non-

affiliated existing credit claimant which carries on the business

activity of the predecessor existing credit claimant, the acquired

business activity will be treated as a pre-existing business of the

acquiring corporation. A non-affiliated acquiring corporation will not

be bound by any section 936(h) election made by the predecessor

existing credit claimant with respect to that business activity.

(B) Where all of the assets of a pre-existing business of an

existing credit claimant are acquired by a corporation that is not an

existing credit claimant, if the acquiring corporation makes a section

936(e) election for the taxable year in which the assets are acquired--

(1) The acquiring corporation will be treated as an existing credit

claimant for the year of acquisition;

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

acquiring corporation;

(3) The acquiring corporation will be deemed to satisfy the rules

of section 936(a)(2) for the year of acquisition; and

(4) After making an election under section 936(e), a non-affiliated

acquiring corporation will not be bound by elections under sections

936(a)(4) and (h) made by the predecessor existing credit claimant.

(C) A mere change in the stock ownership of a possessions

corporation will not affect its status as an existing credit claimant

for purposes of this section.

(4) Timing rule. The tests for a new line of business in this

paragraph (whether the new activity is closely related to a pre-

existing business) are applied only at the end of the taxable year

during which the new activity is added.

(c) Substantial--(1) In general. For purposes of section 936 and

section 30A, a new line of business is considered to be substantial as

of the earlier of--

(i) The taxable year in which the possessions corporation derives

more that 15 percent of its gross income from that new line of business

(gross income test); or

(ii) The taxable year in which the possessions corporation directly

uses in that new line of business more that 15 percent of its assets

(assets test).

(2) Gross income test. The denominator in the gross income test is

the amount that is the gross income of the possessions corporation for

the current taxable year, while the numerator is the amount that is the

gross income of the new line of business for the current taxable year.

The gross income test is applied at the end of each taxable year. For

purposes of this test, if a new line of business is added late in the

taxable year, the income is not to be annualized in that year. In the

case of a new line of business acquired through the purchase of assets,

the gross income of such new line of business for the taxable year of

the acquiring corporation that includes the date of acquisition is

determined from the date of acquisition through the end of the taxable

year. In the case of a consolidated group election made pursuant to

section 936(i)(5), the test applies on a company by company basis and

not on a consolidated basis.

(3) Assets test--(i) Computation. The denominator is the adjusted

tax basis of the total assets of the possessions corporation for the

current taxable year. The numerator is the adjusted tax basis of the

total assets utilized in the new line of business for the current

taxable year. The assets test is computed annually using all assets

including cash and receivables.

(ii) Exception. A new line of business of a possessions corporation

will not be treated as substantial as a result of meeting the assets

test if an event that is not reasonably anticipated causes assets used

in the new line of business of the possessions corporation to exceed 15

percent of the adjusted tax basis of the possession corporation's total

assets. For example, an event that is not reasonably anticipated would

include the destruction of plant and equipment of the pre-existing

business due to a hurricane or other natural disaster, or other similar

circumstances beyond the control of the possessions corporation. The

expiration of a patent is not such an event and will not trigger this

exception.

(d) Examples. The following examples illustrate the rules described

in paragraphs (a), (b), and (c) of this section. In the following

examples, X Corp. is an existing credit claimant unless otherwise

indicated:

Example 1. X Corp. is a pharmaceutical corporation which

manufactured bulk chemicals (a component product). In March 1997, X

Corp. began to also manufacture pills (e.g., finished dosages or an

integrated product). The new activity provides products very similar

to the products provided by the pre-existing business. The new

activity is of a type that is normally conducted in the same

business location as the pre-existing business. The activity's

economic success depends on the success of the pre-existing

business. The manufacture of bulk chemicals is in NAICS code 325411,

Medicinal and Botanical Manufacturing, while the manufacture of the

pills is in NAICS code 325412, Pharmaceutical Preparation

Manufacturing. Although the products have a different end-use, may

be marketed to a different class of customers, and may not use

similar operating assets, they are within the same five-digit NAICS

code and the activity also satisfies paragraphs (b)(2)(i) (A), (C),

and (E) of this section. The manufacture of the pills by X Corp.

will be considered closely related to the manufacture of the bulk

chemicals. Therefore, X Corp. did not add a new line of business

because it falls within the safe harbor rule of paragraph

(b)(2)(ii)(B) of this section.

Example 2. X Corp. currently manufactures printed circuit boards

in a possession. As a result of a technological breakthrough, X

Corp. could produce the printed circuit boards more efficiently if

it modified its existing production methods. Because demand was

high, X Corp. expanded its facilities to support the production of

its current products when it modified its production methods. After

these modifications to the facilities and production methods, the

products produced through the new technology were in the same six-

digit NAICS code as products produced previously by X Corp. See

paragraph (b)(2)(ii)(A) of this section. Therefore, X Corp. will not

be

[[Page 44391]]

considered to have added a new line of business for purposes of

paragraph (b) of this section.

Example 3. X Corp. has manufactured Device A in Puerto Rico for

a number of years and began to manufacture Device B in Puerto Rico

in 1997. Device A and Device B are both used to conduct electrical

current to the heart and are both sold to cardiologists. There is no

significant change in the type of activity conducted in Puerto Rico

after the transfer of the manufacturing of Device B to Puerto Rico.

Similar manufacturing equipment, manufacturing processes and skills

are used in the manufacture of both devices. Both are regulated and

licensed by the Food and Drug Administration. The economic success

of Device B is dependent upon the success of Device A only to the

extent that the liability and manufacturing prowess with respect to

one reflects favorably on the other. Depending upon the heart

abnormality, the cardiologist may choose to use Device A, Device B

or both on a patient. Both devices are within the same business

sector of the taxpayer's business. The manufacture of Device A is in

the six-digit NAICS code 339112, Surgical and Medical Instrument

Manufacturing. The manufacture of Device B is in the six-digit NAICS

code 334510, Electromedical and electro-therapeutic Apparatus

Manufacturing. (The manufacture of Device A is in the four-digit SIC

code 3845, Electromedical and Electrotheraputic Apparatus. The

manufacture of Device B is in the four-digit SIC code 3841, Surgical

and Medical Instruments and Apparatus.) The safe harbor of paragraph

(b)(2)(ii)(B) of this section applies because the two activities are

within the same three-digit SIC code and Corp. X satisfies

paragraphs (b)(2)(i) (A), (B), (C), (D), (F), and (G) of this

section.

Example 4. X Corp. has been manufacturing house slippers in

Puerto Rico since 1990. Y Corp. is a U.S. corporation that is not

affiliated with X Corp. and is not an existing credit claimant. Y

Corp. has been manufacturing snack food in the United States. In

1997, X Corp. purchased the assets of Y Corp. and began to

manufacture snack food in Puerto Rico. House slipper manufacturing

is in the six-digit NAICS code 316212 (Four-digit SIC code 3142,

House Slippers). The manufacture of snack foods falls under the six-

digit NAICS code 311919, Other Snack Food Manufacturing (four-digit

SIC code 2052, Cookies and Crackers (pretzels)). Because these

activities are not within the same five or six digit NAICS code (or

the same three or four-digit SIC code), and because snack food is

not an integrated product that contains house slippers, the safe

harbor of paragraph (b)(2)(ii) of this section cannot apply.

Considering all the facts and circumstances, including the eight

factors of paragraph (b)(2)(i) of this section, the snack food

manufacturing activity is not closely related to the manufacture of

house slippers, and is a new line of business, within the meaning of

paragraph (b) of this section.

Example 5. X Corp. is an existing credit claimant that has

elected the profit-split method for computing taxable income. P

Corp. was not an existing credit claimant and manufactured a product

in a different five-digit NAICS code than the product manufactured

by X Corp. In 1997, X Corp. acquired the stock of P Corp. and

liquidated P Corp. in a tax-free liquidation under section 332, but

continued the business activity of P Corp. as a new business

segment. Assume that this new business segment is a new line of

business within the meaning of paragraph (c) of this section. In

1997, X Corp. has gross income from the active conduct of a trade or

business in a possession computed under section 936(a)(2) of $500

million and the adjusted tax basis of its assets is $200 million.

The new business segment had gross income of $60 million, or 12

percent of the X Corp. gross income, and the adjusted basis of the

new segment's assets was $20 million, or 10 percent of the X Corp.

total assets. In 1997, X Corp. does not derive more than 15 percent

of its gross income, or directly use more that 15 percent of its

total assets, from the new business segment. Thus, the new line of

business acquired from P Corp. is not a substantial new line of

business within the meaning of paragraph (c) of this section, and

the new activity will not cause X Corp. to lose its status as an

existing credit claimant during 1997. In 1998, however, the gross

income of X Corp. grew to $750 million while the gross income of the

new line of business grew to $150 million, or 20% of the X Corp.

1998 gross income. Thus, in 1998, the new line of business is

substantial within the meaning of paragraph (c) of this section, and

X Corp. loses its status as an existing credit claimant as of

December 31, 1997.

(e) Loss of status as existing credit claimant. An existing credit

claimant that adds a substantial new line of business in a taxable

year, or that has a new line of business that becomes substantial in a

taxable year, loses its status as an existing credit claimant as of the

close of the taxable year ending before either such taxable year. In

such case, the possession corporation must not claim the Puerto Rico

and possession tax credit on its return for the taxable year in which

the substantial new line of business is added or a new line of business

becomes substantial.

(f) Effective date--(1) General rule. This section applies to

taxable years of a possessions corporation beginning after August 19,

1998.

(2) Election for retroactive application. Taxpayers may elect to

apply retroactively all the provisions of this section for any open

taxable year beginning after December 31, 1995. Such election will be

effective for the year of the election and all subsequent taxable

years. This section will not apply to activities of pre-existing

businesses for taxable years beginning before January 1, 1996.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved:

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 98-21826 Filed 8-18-98; 8:45 am]

BILLING CODE 4831-01-U