OMJ Pharmaceuticals, Inc. v. United States , 753 F.3d 333 ( 2014 )

United States Court of Appeals
For the First Circuit
No. 13-1008
OMJ PHARMACEUTICALS, INC.,
Plaintiff, Appellant,
v.
UNITED STATES OF AMERICA,
Defendant, Appellee.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF PUERTO RICO
[Hon. Gustavo A. Gelpí, U.S. District Judge]
Before
Torruella, Lipez, and Kayatta,
Circuit Judges.
William L. Goldman, with whom Robin L. Greenhouse, Nathaniel
J. Dorfman, McDermott Will & Emery LLP, Jerome A. Swindell,
Assistant General Counsel, and Johnson & Johnson were on brief, for
appellant.
Teresa E. McLaughlin, Attorney, Tax Division, with whom
Bethany B. Hauser, Attorney, Tax Division, and Kathryn Keneally,
Assistant Attorney General, were on brief, for appellee.
June 3, 2014
KAYATTA, Circuit Judge. From 1976 until 1996, section
936 of the Internal Revenue Code made available to U.S.
corporations a tax credit fully offsetting the federal tax owed on
income earned in the operation of any trade or business in Puerto
Rico. In 1996, Congress enacted the Small Business Job Protection
Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755, setting in motion
the complete repeal of section 936, ameliorated by a ten-year
transition period during which the credit remained available only
to taxpayers who had claimed it in previous years. During the
final eight years of that transition period, the taxable income
that an eligible claimant could take into account in computing its
credit was capped at an amount roughly equal to the average of the
amounts it had claimed in previous years. Though the cap was
generally fixed, it could be adjusted up or down to account for a
taxpayer's purchases and sales of businesses that had themselves
generated credit-eligible income. Thus, as the parties agree, if
one U.S. corporation sold to a second U.S. corporation a business
that accounted for $1 million in average prior year credit claims,
the credit cap for the purchasing corporation would normally
increase by $1 million, and the credit cap for the selling
corporation would normally drop by the same amount.
This appeal requires us to decide, in a case of first
impression, the effect on a U.S. taxpayer's credit cap of a sale of
a line of business in Puerto Rico to a foreign corporation that
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does not pay U.S. corporate income taxes. Having made three such
sales, appellant OMJ Pharmaceuticals, Inc. ("OMJ"), argues that it
was not required to reduce its cap by the amount of credit-eligible
income associated with the lines of business sold because the
buyer, as a foreign corporation, had no credit cap to increase or
even establish. The government disagrees, arguing that regardless
of whether the purchaser of a line of business could increase or
establish a credit cap, a seller was required to reduce its own cap
by the amount associated with the line of business. On cross-
motions for summary judgment, the district court sided with the
government, rejecting OMJ's claim for a tax refund of approximately
$53 million. Because we read the controlling provisions of the
Internal Revenue Code to require otherwise, we reverse and remand
with instructions to enter summary judgment in OMJ's favor.
I. Background
A. The Puerto Rico and Possessions Tax Credit
Between 1976 and 1996, Congress encouraged U.S.
corporations to invest in Puerto Rico and other U.S. territories by
establishing a possessions corporation system of taxation.
Congress implemented that system primarily by creating the "Puerto
Rico and possession tax credit," codified in section 936 of the
Internal Revenue Code. See generally Dep't of the Treasury, The
Operation and the Effect of the Possessions Corporation System of
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Taxation, Sixth Report (1989). As described by the Treasury
Department:
The possessions corporation system of taxation is a set
of rules under which a U.S. corporation deriving
qualifying income from possessions and Puerto Rico pays
no income tax to the United States. As a U.S.
corporation, a possessions corporation is subject to
federal tax on its worldwide income. However, a special
credit available under section 936 fully offsets the
federal tax on income from a trade or business in Puerto
Rico and from qualified possession source investment
income (QPSII). A U.S. parent corporation can, in turn,
offset dividends received from a wholly owned
936 subsidiary with a 100 percent dividends-received
deduction, which frees the dividend income from federal
tax.
Id. at 5.
In 1996, Congress amended section 936 to terminate the
credit, subject to certain transition rules. Small Business Job
Protection Act of 1996, Pub. L. No. 104-188, § 1601, 110 Stat.
1755, 1827, 26 U.S.C § 936 (amended 2007). Under the transition
rules, an existing credit claimant--that is, a taxpayer who
previously claimed the credit, § 936(j)(9)--could continue to claim
the credit for up to ten years, § 936(j)(3). Beginning in the 1998
tax year, however, the amount of the credit became subject to a cap
roughly equal to the annual average of a claimant's inflation-
adjusted possession income for the five taxable years immediately
preceding 1995. See § 936(j)(2)(B), (3)(A), (4), (5).
Though the cap was based on past activity, it was not
entirely fixed. Under certain circumstances, if a taxpayer
acquired a trade or business that itself qualified for the credit,
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the acquiring taxpayer could add to its own cap the historic tax
attributes of the acquired trade or business, enabling the
acquiror's new cap to reflect the historic credit-eligible
expenditures of both entities. See § 936(j)(5)(D); accord H.R.
Rep. No. 104-737, at 292 (1996) (Conf. Rep.) ("The adjusted base
period income of the existing credit claimant from which the assets
are acquired is divided between such corporation and the
corporation that acquires such assets."). The selling corporation
would then subtract from its cap the same amounts.
B. OMJ's Transactions
OMJ is a Delaware corporation that (among other things)
develops, manufactures, and distributes healthcare products. Its
principal place of business is Puerto Rico. Between 1993 and 1998,
OMJ reported income from manufacturing operations in Puerto Rico.
The parties agree that throughout the period on which this
litigation is focused, OMJ remained eligible to claim the section
936 credit.
On November 30, 1998, OMJ transferred three of its
wholly-owned subsidiaries--Janssen Ortho, LLC, Ortho Biologics,
LLC, and Lifescan, LLC--to a fourth company. That fourth company,
OMJ Ireland, Ltd. ("OMJ Ireland"), was an Irish corporation also
owned entirely by OMJ. OMJ Ireland had never paid or been required
to pay U.S. income taxes.
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After the transfers, OMJ paid income tax for 1999 and
2000 in the amounts it would have owed had its credit cap been
reduced by the amount associated with the three businesses it sold.
Later, however, OMJ filed two amended returns, claiming a refund of
$27,537,675 (which it later adjusted to $22,874,764) for 1999 and
a refund of $37,928,839 (which it later adjusted to $30,094,104)
for 2000, justifying each on the ground that the credit cap
reduction was unnecessary. The Internal Revenue Service disagreed
and denied the refunds. OMJ, in pursuit of its refund claims,
filed this suit soon afterwards.
The district court, concluding that section 936 required
a credit cap reduction upon the sale of any trade or business, no
matter who the buyer, granted summary judgment to the United
States. OMJ appealed.
II. Standard of Review
We review the district court's grant of summary judgment
de novo. Shafmaster v. United States, 707 F.3d 130, 135 (1st Cir.
2013); see also Prokey v. Watkins, 942 F.2d 67, 72 (1st Cir. 1991)
(reciting the "familiar" principle that summary judgment is
"appropriate when the pleadings and other submissions 'show that
there is no genuine issue as to any material fact and that the
moving party is entitled to judgment as a matter of law.'" (quoting
Fed. R. Civ. P. 56)). In conducting our de novo review, we accord
to the IRS Commissioner "a presumption of correctness, so the
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taxpayer bears the burden of proving that an assessment was
erroneous." Shafmaster, 707 F.3d at 135 (citing Hostar Marine
Transp. Sys., Inc. v. United States, 592 F.3d 202, 208 (1st Cir.
2010)). Adding heft to this burden is the principle, applicable
here, that because "[i]ncome tax deductions and credits are matters
of legislative grace," MedChem (P.R.), Inc. v. Comm'r, 295 F.3d
118, 123 (1st Cir. 2002), "credit should be allowed only where
there is 'clear provision therefor.'" Id. (quoting New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)).
III. Analysis
This case arises in part because neither Congress nor the
IRS wrote any rules for implementing the details of the credit cap
adjustments. Rather, in the portion of the tax code governing the
possessions credit transition period, Congress provided as follows:
"ACQUISITIONS AND DISPOSITIONS.--Rules similar to the rules of
subparagraphs (A) and (B) of section 41(f)(3) shall apply for
purposes of this subsection." 26 U.S.C. § 936(j)(5)(D).
Section 41(f)(3), which has nothing to do with the possessions
corporation tax regime aside from this cross reference, generally
governed the calculation of the tax credit for increases in
research expenditures. The parties are in agreement that section
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936 should be interpreted to create a framework as similar as
possible to section 41's.1
We take it as an undisputed given that Congress looked to
section 41 because that section implemented a framework, like the
one created by section 936, under which calculation of a tax
benefit was driven in great part by the taxpayer's experience in
prior years. In creating the credit for expenditures on qualified
research, Congress chose to limit the credit to increases in
research spending. In simplified form, research spending in a
given year established a floor above which such spending had to
rise in a subsequent year in order to justify a credit, which would
be limited to the incremental increase.
The comparison of one year to another for calculating the
credit under section 41 posed the question of what to do when a
company sold a line of business to which some or all of the prior
year's research expenditures were devoted. For example, a company
buying such a line of business might plausibly claim to have
incrementally increased its own research spending in the year
following the acquisition, even though it merely added to its prior
research spending that of the acquired business line. In adopting
1
At oral argument, the government emphasized that section
936 and section 41(f)(3) "have to be applied the same way," and
that "whether the attributes go away, or go to the acquiror, has to
be the same in both cases." There being nothing in the statute or
legislative history to compel a different reading, we adopt here
the parties' preferred construction.
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section 41(f)(3), Congress rejected that position, instead
reflecting in the statute its judgment that such transactions
involve mere shifts of spending from firm to firm, rather than
increases in overall research spending. Accord H.R. Rep. No. 97-
201, at 124-25 (1981) ("If the provision did not include rules for
changes in ownership of a business, a taxpayer who begins business
by buying and operating an existing company might be entitled to a
credit even if the amount of qualified research expenditures were
not increased."). To avoid creating a tax credit for such shifts,
Congress provided as follows:
(3) Adjustments for certain acquisitions, etc.--Under
regulations prescribed by the Secretary–
(A) Acquisitions.--If, after December 31, 1983, a
taxpayer acquires the major portion of a trade or
business of another person (hereinafter in this paragraph
referred to as the "predecessor") or the major portion of
a separate unit of a trade or business of a predecessor,
then, for purposes of applying this section for any
taxable year ending after such acquisition, the amount of
qualified research expenses paid or incurred by the
taxpayer during periods before such acquisition shall be
increased by so much of such expenses paid or incurred by
the predecessor with respect to the acquired trade or
business as is attributable to the portion of such trade
or business or separate unit acquired by the taxpayer,
and the gross receipts of the taxpayer for such periods
shall be increased by so much of the gross receipts of
such predecessor with respect to the acquired trade or
business as is attributable to such portion.
26 U.S.C. § 41(f)(3) (amended 2013).
And to address the opposite problem--the possibility that
a company that merely sold a line of business might be faulted for
decreasing its research (even though that research was continued by
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another)--Congress addressed the sell side of such transactions in
the next subparagraph:
(B) Dispositions.--If, after December 31, 1983–
(i) a taxpayer disposes of the major portion of any
trade or business or the major portion of a
separate unit of a trade or business in a
transaction to which subparagraph (A) applies, and
(ii) the taxpayer furnished the acquiring person
such information as is necessary for the
application of subparagraph (A),
then, for purposes of applying this section for any
taxable year ending after such disposition, the amount of
qualified research expenses paid or incurred by the
taxpayer during periods before such disposition shall be
decreased by so much of such expenses as is attributable
to the portion of such trade or business or separate unit
disposed of by the taxpayer, and the gross receipts of
the taxpayer for such periods shall be decreased by so
much of the gross receipts as is attributable to such
portion.
Id.
Staying for the moment with the treatment of the research
credit floor, the question posed by analogy in this case is how to
treat a seller under section 41(f)(3)(B) when a line of business is
sold to a foreign corporation that pays no U.S. corporate income
tax and to whom there would therefore be no basis for an adjustment
under the buy-side provision of subparagraph (A). OMJ argues that
in such a case, the seller would not have been entitled to decrease
its research credit floor, because such a decrease was required
only after a transaction that triggers a buy-side increase under
subparagraph (A). And if the sale would not have decreased the
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seller's research credit floor, reasons OMJ, then it cannot have
decreased its possessions tax credit cap.
The United States balks at OMJ's straightforward reading
of section 41(f)(3). The government argues that
section 41(f)(3)(A) would indeed "apply" to an acquisition of a
business line by any "acquiring person," whether or not that person
paid any U.S. corporate income tax--which is to say, whether or not
there could be any buy-side increase in the research credit floor.
The government's reading, however, would mean that the sell-side
adjustments are made any time there is a sale of a trade or
business, because in every sale there is an acquiror. But if
Congress had intended such a result, it could easily have so
stated, and there would have been no reason for the cross-reference
to subparagraph (A). Indeed, the cross-reference in (B) to
"transaction[s] to which subparagraph (A) applies" strongly
indicates that there must be some dispositions of credit-generating
trades or businesses to which subparagraph (A) does not apply,
unless the last eight words of subparagraph (B)--"in a transaction
to which subparagraph (A) applies"--are to be treated simply as
surplusage. See generally Duncan v. Walker, 533 U.S. 167, 175
(2001) ("We are . . . reluctan[t] to treat statutory terms as
surplusage . . . ." (alteration in original) (internal quotation
marks omitted)); MedChem (P.R.), Inc. v. Comm'r, 295 F.3d 118, 125-
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26 (1st Cir. 2002) (rejecting an interpretation of section 936 that
would have rendered a term redundant).
The government briefly argues that because the Department
of the Treasury has, by regulation, defined the term "acquisition"
to include a "liquidation," see Treas. Reg. § 1.41-7(b), it follows
that any liquidation of a major portion of a business can generate
a subparagraph (B) reduction--even if the liquidation does not
result in a corresponding increase in the research credit floor of
a buyer. The failures of this logic are manifold. Most
importantly, the argument assumes that if the word "acquisitions"
is defined to include a particular type of transaction, then any
transaction of that type will give rise to a decrease under
subparagraph (B). But the rule that dictates the outcome in this
case has nothing to do with the breadth of the term
"acquisitions"--a term that appears nowhere in subparagraph (B).
Instead, we are guided by the basic principle (on which regulation
§ 1.41-7(b) casts precisely no doubt) that subparagraph (B) applies
only to dispositions involving transactions "to which subparagraph
(A) applies." Liquidation or not, a transaction that does not
involve a buyer is not one to which subparagraph (A)--a provision
aimed explicitly and exclusively at the behavior of a purchaser of
a major portion of a trade or business--applies.
The government's fallback position is that even if
subparagraph (A) does not apply to every transaction involving a
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credit-generating business, it applies whenever the acquiror may be
subject to payment of any type of U.S. tax, whether or not it pays
the type of tax--corporate income tax--that could be affected by an
increase in the research credit floor. We cannot agree.
Subparagraph (A) refers not only to "a taxpayer," but also to
modifications of qualified research expenses and gross receipts--
modifications that are possible only if the acquiring party is
subject to the sorts of taxes to which the credits at issue apply.
To say that subparagraph (A) "applies," therefore, is to suggest
that there is something that might undergo the specified
adjustments. The government's myopic focus on the term "taxpayer"
simply obscures the broader point that, "taxpayer" or not, a sale
to an entity that has no obligations under subparagraph (A) is not
a transaction to which subparagraph (A) applies.
This reading of subparagraph (A) is reinforced by
unambiguous textual indications elsewhere in section 41(f)(3). For
example, although the government argues that subparagraph (B)(ii)
broadens subparagraph (B)'s applicability by referring to an
"acquiring person," rather than an "acquiring taxpayer,"
subparagraph (B)(ii) in fact explicitly restricts the scope of that
provision by expressing the additional requirement that in order to
avail itself of a decrease, a sell-side taxpayer must "furnish[]
the acquiring person such information as is necessary for the
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application of subparagraph (A)." We glean two points from this
language.
First, the language confirms that not every sale results
in a decrease in the research credit floor. If the seller fails to
give the buyer the "information as is necessary for the application
of subparagraph (A)," the subparagraph (B) reduction does not
occur.
Second, and even more saliently, the statute's
recognition that information is needed from the seller in order to
allow "application of subparagraph (A)" strongly implies that
"application" means some adjustment to the buyer's U.S. corporate
tax attributes. The "application of subparagraph (A)" thus most
naturally means the use of subparagraph (A) to require an increase
in the buyer's research credit floor. And although the government
relies on legislative history to suggest that Congress understood
the interaction of subparagraphs (A) and (B) differently, that
history demonstrates precisely the opposite. See H.R. Rep. No. 97-
201, at 125 (1981) ("This relief [i.e., the subparagraph (B)(ii)
decrease] is not provided unless the taxpayer furnishes the
acquiring person with information needed to compute the credit
under the acquisition rules described in [subparagraph (A)]."). In
short, section 41(f)(3)'s language and legislative history compel
the conclusion that the decrease under subparagraph (B) cannot
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occur when the buyer is not a U.S. corporate taxpayer, because in
such a case, subparagraph (A) cannot apply.
Undaunted by these considerations, the United States
proposes that we disregard the strong indications given by the
language of subparagraphs (A) and (B) in favor of certain policy
concerns that it suggests animated Congress's adoption of the
provisions at issue. Given the government's insistence that we
interpret section 936 as creating an adjustments regime as similar
as possible to the one under section 41(f)(3), one might reasonably
expect such policy arguments to focus primarily on the concerns
underlying the research increase tax credit. But instead, the
government points us to subparagraph 936(j)(9)(B), a provision with
no section 41 analog, which states that "[i]f . . . a corporation
which would (but for this subparagraph) be an existing credit
claimant adds a substantial new line of business [other than one
that itself counts as an existing credit claimant] such corporation
shall cease to be treated as an existing credit claimant . . . ."
The government suggests that subparagraph (j)(9)(B)
evinces Congress's intention to prevent corporations from claiming
possessions tax credits for so-called organic growth. And the
district court, though observing that such an at-all-costs pursuit
of that policy would be "difficult to reconcile" with subparagraph
(B)'s plain indication that a decrease is required only in the
event of a corresponding increase, nevertheless agreed. It is on
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this argument that the United States, largely waving to one side
section 41's language, relies most heavily on appeal.
If the organic growth to which the government refers is
the building of a new line of business that did not previously
account for existing credits, then the government is certainly
correct that subparagraph 936(j)(9)(B) evidences a disfavoring of
such growth as a basis for credit generation. But there is no
claim that OMJ grew such a new line of business. And while it is
true that OMJ's construction of section 936(j)(5)(D) would likely
not have benefitted OMJ unless it had some new income against which
to apply the credit retained following the sales, Congress
manifested no intention to disfavor use of the credit to offset
income earned as a result of growth within pre-existing, retained
lines of business. Indeed, the fact that Congress limited
section 936(j)(9)(B) to the addition of new business lines
evidences a decision not to apply its concepts to what would have
been an obvious other form of growth not included in
subsection 936(j)(9)(B). In this regard, subsection 936(j)(9)(B)
actually undercuts the government's position.
The government's suggestion that Congressional intent
requires us to read subparagraph (j)(9)(B) more broadly than its
text would seem to allow also runs counter to the principle that,
as a general matter, "[t]he best indication of Congress's
intentions . . . is the text of the statute itself." E.g., South
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Port Marine, L.L.C. v. Gulf Oil Ltd. P'ship, 234 F.3d 58, 65 (1st
Cir. 2000); see also In re Rudler, 576 F.3d 37, 44 (1st Cir. 2009)
("If the statute's language is plain, 'the sole function of the
courts--at least where the disposition required by the text is not
absurd--is to enforce it according to its terms.'" (quoting Lamie
v. United States, 540 U.S. 526, 534 (2004) (internal quotation
marks omitted))). Whether or not we call the text of 41(f)(3)
indisputably plain, all must agree that it does not read as one
would expect it to had Congress intended that all sales of business
lines would decrease a seller's cap. And, as we have observed, the
legislative history supports this reading of section 41(f)(3) by
confirming that Congress understood that a decrease would be
available only when triggered by a buy-side increase.
Our interpretation is reinforced further by stepping back
from a microscopic examination of a particular transaction and
looking at the general impact of the parties' competing
interpretations. Both the structure of the statute and the entire
nature of the possessions tax regime make clear that the object of
Congress's attention was the Puerto Rican economy. In terminating
the possessions tax regime, Congress apparently intended to provide
a transition period during which pre-existing credits for existing
lines of business would generally remain viable, neither increasing
nor decreasing. Section 936 furthers this apparent aim by ensuring
that any increases in caps on the buy side would be offset by
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decreases on the sell side, leaving the balance of caps in Puerto
Rico as a whole largely unaffected. To have required a decrease
when there could have been no increase would have thrown off that
balance and marginally decreased the size of the transitional
cushion. We see no indication that such was Congress's intent.
Nor does the government claim that the reading of sections 41 and
936 for which OMJ advocates could be exploited to increase the
total amount of credit claimed beyond the amount that could have
been claimed but for the sale. Indeed, given that the section 936
transition period long ago expired,2 the government can point to no
adverse collateral effects of applying the statute as it most
naturally reads.
IV. Conclusion
As we observed at the outset of our discussion of
section 936, the government adopted no rules addressing exactly how
section 936(j)(5)(D) would work. Instead, the government joins
with OMJ in suggesting that the framework must replicate, as much
as is possible, the rules expressed in section 41(f)(3). The
2
Congress recently amended section 41(f)(3) to replace the
phrase "taxpayer" in subparagraph (A) with the phrase "acquiring
person," mooting for future research credit cases any need to
decide what the word taxpayer means. See American Taxpayer Relief
Act of 2012, Pub. L. No. 112-240, § 301(b), 126 Stat. 2313, 2326-
2328 (2013). Naturally, OMJ suggests that this reflects Congress's
determination that a policy change was due, while the government
suggests that the amendment was intended to codify what has always
been understood. In light of our conclusion that other sources of
insight render the statute's meaning unambiguous, neither argument
exerts much force.
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language, structure, purpose, and history of those rules point
uniformly to the conclusion that a reduction in a seller's cap as
a result of the sale of a business line is appropriate only in the
event of a corresponding increase in the buyer's cap. And since
there is no claim that the transaction at issue in this case
increased or could have increased any credit cap attributed to OMJ
Ireland or its subsidiaries, the transfers did not reduce OMJ's
credit cap. We therefore reverse the district court's order
granting summary judgment to the United States and remand for the
entry of summary judgment in OMJ's favor.
So ordered.
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