Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 79-97

1979-1 C.B. 39

Section 47
Section 48
Section 936
Section 1502
Section 1504

IRS Headnote

Recapture of investment credit; member of affiliated group; section 936 election. A member of an affiliated group, that filed consolidated income tax returns in prior years and properly claimed an investment credit in one such year, files a separate return claiming the Puerto Rico and Possessions tax credit. The member is liable, in the year the section 936 election is made, for increased income tax resulting from the recapture of that portion of investment credit, taken in the prior year, that is attributable to new section 38 property placed in service by the member. Rev. Rul. 73-76 distinguished.

Full Text

Rev. Rul. 79-97

ISSUE

How do the recapture provisions of section 47 of the Internal Revenue Code of 1954 apply to the investment credit attributable to the section 38 property of a member corporation of an affiliated group that had been filing a consolidated income tax return when the property ceased to be "section 38 property" because the member corporation elected the benefits of section 936?

FACTS

P is a domestic corporation engaged in the business of manufacturing. P is the common parent of an "affiliated group," as defined in section 1504 of the Code, and files a consolidated federal income tax return. S, a wholly-owned domestic subsidiary of P, is engaged in the business of manufacturing and selling within the Commonwealth of Puerto Rico. During 1975 and 1976 S was engaged in manufacturing activities in Puerto Rico. In those years, S had no gross income, but S had net operating losses and therefore did not claim the benefits of either section 931 in 1975 (amended and redesignated section 936 for domestic corporations doing business in Puerto Rico, by the Tax Reform Act of 1976) or section 936 in 1976. For its calendar years 1975 and 1976, S was an "includible corporation," as that term is defined in section 1504(b), in P's affiliated group. An investment credit of 10x dollars was properly claimed by the affiliated group in 1976 and 2x dollars of that credit was directly attributable to "new section 38 property" placed in service in 1976 in Puerto Rico by S.

In 1977, S continued to be engaged in manufacturing activities in Puerto Rico but had gross income and net profits and elected the benefits of section 936 of the Code. S qualified under section 936's 3-year gross income tests in 1977, because when the 2 years of 1975 and 1976, in which S had no gross income, were considered with 1977, the year in which S had gross income exclusively from activities in Puerto Rico, the 3-year total met and exceeded both the 80 percent and 50 percent requirements of section 936(a).

LAW AND ANALYSIS

Section 936 of the Code permits a domestic corporation to elect a tax credit ("possessions corporation credit" or "section 936 credit") for an amount equal to the income tax that would be imposed on taxable income from sources without the United States from the active conduct of a trade or business within a possession of the United States and from qualified possession source investment income if 80 percent or more of the gross income of such corporation for the 3-year period immediately preceding the close of the taxable year (or for such part of such period immediately preceding the close of such taxable year as may be applicable) was derived from sources within a possession of the United States (determined without regard to section 904(f)) and if 50 percent or more of its gross income for such period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States. Section 936(d)(1) provides that the term "possession of the United States" includes the Commonwealth of Puerto Rico.

Section 1504(a) of the Code provides generally that the term "affiliated group" means one or more chains of corporations connected through stock ownership with a common parent corporation. Section 1504(b)(4), in defining an "includible corporation," specifically excludes from such term "corporations with respect to which an election under section 936 (relating to possession tax credit) is in effect for the taxable year." Therefore, under section 1504(b)(4), S does not qualify in 1977 as an includible corporation in P's affiliated group by virtue of its having met the gross income tests of section 936(a) for the 3-year period and because the benefits of section 936 were elected for 1977.

Section 48(a)(2)(A) of the Code states the general rule that "section 38 property" does not include property that is used predominantly outside the United States. Section 48(a)(2)(B)(vii) provides an exception to this rule for property that is owned by a domestic corporation and used predominantly in a possession of the United States, so long as the corporation is not one that has an election in effect under section 936. Thus, as a result of section 48(a)(2)(B)(vii), when S claims the benefits of section 936 its property that qualified as section 38 property in 1976 ceases to be section 38 property in 1977.

Section 47(a) of the Code provides, in part, that if any property is disposed of, or otherwise ceases to be section 38 property with respect to the taxpayer, before the close of the useful life that was taken into account in computing the investment credit, such credit, or a portion thereof, shall increase the taxpayer's liability for tax for the year of disposition or cessation.

Section 1.47-2(a)(2) of the Income Tax Regulations provides that in order to determine whether there is a change in status of the property, the taxpayer must in each year after the credit year determine whether the property in issue would qualify as section 38 property if it were placed in service that year.

Since S's tax liability for 1977 was determined in accordance with section 936 of the Code, the property placed in service in 1976 no longer qualifies for treatment under the exception provided by section 48(a)(2)(B)(vii). Therefore, the property ceased to qualify as section 38 property in 1977.

Section 1.47-1(c)(1)(ii)(b) of the regulations provides, in part, that if during the taxable year, property on which the investment credit was claimed ceases to be section 38 property for any reason other than the occurrence of an event on a specific date, such cessation shall be treated as having occurred on the first day of such taxable year.

The property in question ceased to qualify as section 38 property because S met the income requirements of section 936 and not because of an event occurring on a specific day in 1977. Therefore, S's property ceased to be section 38 property as of January 1, 1977.

Section 1502 of the Code authorizes the Secretary to prescribe regulations to determine the tax liability of any affiliated group of corporations filing a consolidated return, and of each corporation in the group, for tax years during and after the period of affiliation.

Section 1.1502-3(f) of the regulations provides that if section 38 property is subject to recapture with respect to a corporation during a taxable year for which the corporation files a separate return, any increase in tax shall be added to the tax liability of the corporation (regardless of whether the property was placed in service in a consolidated or separate return year). See also section 1.47-1(b)(1) which provides that any increase in income tax under section 1.47-1 shall be treated as income tax imposed on the taxpayer by chapter 1 of the Code for the recapture year notwithstanding that without regard to such increase the taxpayer has no income tax liability, has a net operating loss for such taxable year, or no income tax return was otherwise required for such taxable year.

The present situation is distinguishable from Rev. Rul. 73-76, 1973-1 C.B. 31, which requires investment credit recapture in the taxable year prior to a change in taxable status. Rev. Rul. 73-76 deals with a taxable corporation that becomes tax-exempt under section 501 of the Code. In such a situation the principles involved are analogous to those applicable when a corporate taxpayer liquidates; that is, the recapture takes place in the liquidating corporation's final taxable year. See Rev. Rul. 70-391, 1970-2 C.B. 3. Similarly, when a corporation becomes tax-exempt, the recapture should be made with respect to the corporation's last taxable year. The reason for this is that when the taxable entity became a tax-exempt entity, it allowed a cessation of entitlement to occur. Since the now exempt organization is no longer subject to the tax imposed by Chapter 1 of the Code (except on unrelated business income), the taxable entity, in its final taxable year, is the party subject to recapture. Such a result is necessary in order to fulfill the purpose of the recapture provision and to prevent an unwarranted tax benefit.

The situation at hand does not involve a corporation that becomes tax-exempt; rather, it involves a corporation that elects the benefits of section 936 of the Code. Section 936 grants certain corporations a tax credit; it does not make a corporation tax-exempt. A corporation claiming treatment under section 936 remains subject to the tax imposed by Chapter 1 of the Code. The recapture, in such a situation, should take place in the same taxable year that the property ceases to qualify for investment credit, that is, the year in which the taxpayer properly claims treatment under section 936.

HOLDING

Because S's property ceased to be section 38 property in 1977, a separate return year, there is a recapture by S of the investment credit attributable to that property. Thus, the recaptured amount, 2x dollars, must increase S's tax liability for its 1977 taxable year.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 73-76 is distinguished.