[Federal Register Volume 63, Number 160 (Wednesday, August 19, 1998)]
[Rules and Regulations]
[Pages 44387-44391]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-21826]


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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