The nation's major pharmaceutical companies and the government of Puerto Rico are battling to save a provision of the U.S. tax code that permits the companies to escape taxes on billions of dollars in profits annually in exchange for putting factories on the island.

The law is under fire both from the Senate, where Budget Committee Chairman Pete V. Domenici (R-N.M.) has singled it out as a loophole without "social merit," and the Internal Revenue Service, which claims the law is being abused.

As far as the Treasury Department is concerned, however, the tax breaks have not done enough. Treasury officials are studying additional incentives to spur island development.

After months of quiet negotiations between U.S. and Puerto Rican officials, Domenici raised the issue publicly on a recent television program. He complained that "the very rich and the very big corporations" are receiving "extreme benefits through legal tax loopholes and tax breaks that don't have any social merit."

Asked for an example, he cited a 60-year-old provision of the tax law that allows U.S. pharmaceutical firms to escape federal taxes on approximately $2.5 billion a year earned by their subsidiaries in Puerto Rico.

The measure originally was enacted to stimulate investment in the Philippines, then a U.S. possession. It is immensely complicated, but in effect it allows U.S. corporations tax credits that offset most of their Puerto Rican profits.

To take advantage of the tax code, the corporations establish Puerto Rican subsidiaries and give them patents and technology enabling them to manufacture the company's product. Most of the Puerto Rican output is then sold on the mainland and at full market prices, but the companies assign all the profits to the tax-exempt Puerto Rican subsidiaries.

Congress requires an annual report from Treasury on the impact of the "Island Possessions" tax law. This year's report was due June 30 but has not yet been submitted, because, according to Treasury Department officials, the entire program of federal tax benefits for Puerto Rico is under review. Norman B. Ture, Treasury undersecretary for tax affairs, visited the island last month as part of the review.

At the same time, the Internal Revenue Service has served notice that it intends to challenge some of the tax benefits that mainland corporations have been receiving. In a "technical advice memorandum," the IRS said that if intangible assets such as patents are transferred to Puerto Rico solely to enable the parent corporation to escape federal taxation, it would allocate some profits for tax purposes to the parent corporation, thus making them taxable.

The Puerto Rican government has retained former IRS general counsel K. Martin Worthy to defend a system it regards as essential to the island's economy. Worthy has challenged the IRS position as "incorrect as a matter of law," according to Tax Notes magazine.

The Treasury Department has not asked for repeal of the tax-break law. On the contrary, it is trying to put together an additional package of tax incentives to provide further stimulus to industrial development on the island.

But Domenici and other key Budget Committee members are contemplating action on this and other industrial tax breaks because, as one staff member put it, "the entire federal budget deficit battle can't be fought on the outlay side," and the existing law is costing the Treasury more than $1 billion a year.

Domenici described the law as giving a "huge tax break" to pharmaceutical companies in Puerto Rico. Technically the law applies to Guam and American Samoa as well (though not to the U.S. Virgin Islands), and to other industries besides pharmaceuticals. In practice, the vast majority of the 565 companies benefiting from the tax break are in Puerto Rico, and nearly half the tax credits go to 16 major pharmaceutical companies, according to Treasury Department figures.

Lewis Engman, president of the Pharmaceutical Manufacturers Association, said yesterday, "Congress enacted the Puerto Rico tax incentive to stimulate economic development in an economically depressed area. That objective is being met. For example, the pharmaceutical industry alone has invested more than $600 million in an economy that previously had no industry of comparable scale."