Rev. Rul. 75-254

Advice has been requested whether, under the circumstances described below, gross income realized by a domestic corporation, on sales of proprietary drug products it manufactures in Puerto Rico that are sold free on board (f.o.b.) Puerto Rico is income from sources within Puerto Rico for purposes of satisfying the 80 percent requirement of section 931(a) of the Internal Revenue Code of 1954.

S, a domestic corporation, is a wholly-owned subsidiary of P, a domestic corporation. S files its returns on the calendar year basis. Prior to taxable year 1973, S manufactured and sold proprietary drug products in the United States and foreign countries. In December 1972 S transferred to M, a newly formed domestic marketing corporation, its United States inventory, accounts receivable, customer lists, and other assets and liabilities relating to the marketing of its products in the United States in exchange for M's stock. S retained its trademarks and trade names, which are registered in the United States and foreign countries. Immediately after the exchange S distributed M's stock to P.

S acquired a manufacturing facility in Puerto Rico and on January 1, 1973, began the manufacture, packaging, and sale of proprietary drug products that it had previously manufactured and packaged in the United States. S sold the proprietary drug products to M at fair market value. Most sales in 1973 were made to M f.o.b. Puerto Rico for resale in the United States. S also sold the proprietary drug products at fair market value directly to customers both in the United States and foreign countries. S, as the owner of its trademarks and trade names, bore all advertising and other expenses related to the maintenance of these trademarks and trade names in the United States. M and the other distributors of S have the right to use S's trademarks only in the advertisement and sale of S's products (similar to the right that is acquired by any purchaser of any trademarked product). Distribution expenses involved in purchasing S's products in Puerto Rico, including warehousing, selling, and delivery to wholesalers and retailers in the United States, are borne by M. These expenses are similar to those that are borne by the independent distributors of S's products in the United States. Neither M nor the independent distributors pay S any separate consideration for the use of S's trademarks in the United States.

Section 931(a)(1) of the Code provides, in part, that in the case of a domestic corporation, gross income means only income from sources within the United States if 80 percent or more of its gross income for the 3-year period immediately preceding the close of the taxable year was derived from sources within a possession of the United States. For purposes of section 931, income is derived from sources within a possession of the United States if it constitutes such income under the applicable provisions of sections 861 through 863.

Section 861(a)(4) of the Code provides, in part, that royalties received by a taxpayer for the use or for the privilege of using trademarks in the United States constitute United States source income.

Rev. Rul. 68-443, 1968-2 C.B. 304, holds that where products are ultimately used in the foreign country where their trademark is protected, a royalty received by the owner of the trademark for its use is income from sources without the United States despite the fact that the initial sale of the trademarked articles took place in the United States. Conversely, any royalty received by S as the owner of the United States trademarks on its products ultimately used in the United States would be income from sources within the United States even though the sale of the trademarked products took place in Puerto Rico.

Therefore, the issue in the instant case is whether any portion of the payments received by S on the ultimate use of its products in the United States would be treated as an imputed royalty for the use of S's trademarks in the United States and would thus be considered United States source income.

A royalty may be defined as a share of the profit reserved by the owner for permitting another to use the property. However, the sale of a trademarked product carries with it the right to use the trademark on the resale of such product. Sunbeam Corp. v. Payless Drug Stores, 113 F. Supp. 31 (N.D. Calif. 1953). Inasmuch as the use of S's trademark by M and the other distributors is not dependent on the grant of such right by S, there are no imputed royalties for the use of S's trademarks or trade names in the United States

Accordingly, gross income received by S in the taxable year 1973 for the sale of its trademarked and trade named proprietary drug products manufactured in Puerto Rico and sold f.o.b., Puerto Rico for resale in the United States, through its domestic affiliate corporation and independent distributors, is income from sources within Puerto Rico.