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To reflect the foregoing and other issues settled by the parties,

Decision will be entered under Rule 155.

Reviewed by the Court.

NIMS, CHABOT, PARKER, WHITAKER, KÖRNER, HAMBLEN, CLAPP, SWIFT, JACOBS, GERBER, WRIGHT, PARR, WILLIAMS, WELLS, RUWE, WHALEN and COLVIN, JJ., agree with this opinion.

BAUSCH & LOMB, INC. AND CONSOLIDATED SUBSIDIARIES, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket No. 3394-86.

Filed March 23, 1989.

Petitioner and its subsidiaries engaged in the manufacture, marketing, and sale of soft contact lenses and related products in the United States and abroad. B&L Ireland was organized on Feb. 1, 1980, under the laws of the Republic of Ireland as a third tier, wholly owned subsidiary of petitioner. B&L Ireland was organized for valid business reasons and to take advantage of certain tax and other incentives offered by the Republic of Ireland. Pursuant to an agreement dated Jan. 1, 1981, petitioner granted to B&L Ireland a nonexclusive license to use its patented and unpatented manufacturing technology to manufacture soft contact lenses in Ireland and a nonexclusive license to use certain of its trademarks in the sale of soft contact lenses produced through use of the licensed technology worldwide. In return, B&L Ireland agreed to pay petitioner a royalty equal to 5 percent of sales. In 1981 and 1982, B&L Ireland engaged in the manufacture and sale of soft contact lenses in the Republic of Ireland. All of B&L Ireland's sales were made either to petitioner or certain of petitioner's wholly owned foreign sales affiliates at a price of $7.50 per lens. Held, respondent abused his discretion under sec. 482, I.R.C. 1954, when he determined that the $7.50 sales price did not constitute an arm's-length consideration for the soft contact lenses sold by B&L Ireland to petitioner. Held, further: The royalty contained in the Jan. 1, 1981, license agreement did not constitute an arm's-length consideration for the use by B&L Ireland of petitioner's

intangibles. However, respondent's adjustment to the royalty
rate was unreasonable. Sec. 1.482-2(d), Income Tax Regs.,
applied to determine an arm's-length consideration for use by
B&L Ireland of petitioner's intangible property.

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I. Research and Development Activities of B&L's Soflens
Division....

554

J. Sales and Marketing Activities of B&L's Soflens Division.
K. Development of the International Soft Contact Lens Mar-
ket....

556

III. Historical Development of the Irish Operations of B&L
Ireland .....

557

A. Background of Decision to Establish Foreign Manufactur-
ing Facility..

557

B. Investigation of and Decision to Establish an Overseas
Manufacturing Facility..

559

C. Negotiations and Agreement Among Petitioners, B&L
Ireland, and the Industrial Development Authority of
the Republic of Ireland

560

D. Manufacturing Intangibles Related to Spin Casting and
Soft Contact Lens Products ....

563

1. Technology in the Public Domain.

563

2. B&L License of Trade Secrets to B&L Ireland

563

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F. Establishment of Manufacturing Operations by B&L Ire

land . . . . .

565

IV. Operations of B&L Ireland in 1981 and 1982 ...

566

A. Production Planning and Scheduling

566

B. Purchases of Raw Materials and Materials Policies

567

C. B&L Ireland's Manufacture of Soft Contact Lenses Using

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F. Pricing Policy With Respect to Intercompany Sales After
Establishment of B&L Ireland....

574

G. Royalties Paid by B&L Ireland to B&L in 1981 and 1982.

574

V. Sales of Soft Contact Lenses by Other Manufacturers During 1981 and 1982....

574

A. American Sterilizer Co. (Lombart)...

B. National Patent Development Corp. (American Hydron)...
1. Sales Under Trademarks of NPDC and its Affiliates....
2. Private Label Sales by NPDC and its Affiliates...

575

575 577

578

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A. Determination of Arm's-Length Prices Between Petitioner
and B&L Ireland for Soft Contact Lenses.

584

B. Determination of Arm's-Length Royalty Payable by B&L
Ireland for use of B&L's Intangibles..

594

Dennis I. Meyer, C. David Swenson, John W. Polk, and A. Duane Webber, for the petitioners.

Joseph R. Goeke, James E. Kagy, and Helen M. Lokey, for the respondent.

KÖRNER, Judge: Respondent determined deficiencies in petitioners' consolidated corporate Federal income tax in the amounts and for the years as follows:

TYE

Dec. 30, 1979...

Dec. 28, 1980...

Dec. 27, 1981...

Deficiency $5,797,857

514,141

2,714,394

The determination of petitioners' 1979, 1980, and 1981 United States consolidated taxable income requires a determination as to petitioners' United States consolidated taxable income for the year 1982 due to net operating loss and foreign tax credit carrybacks.

Among other adjustments made by respondent in his statutory notice, respondent determined that income should be reallocated in the amounts of $2,778,000 and $19,793,750 for the years 1981 and 1982, respectively, from Bausch & Lomb Ireland, Ltd. to Bausch & Lomb Inc. pursuant to section 482.1 Respondent also made correlative adjustments to the income of Bausch & Lomb Inc. of $418,669 and $1,368,000 for the years 1981 and 1982 to eliminate the royalties paid to petitioners by Bausch & Lomb Ireland, Ltd. and deducted on its returns. Thus, respondent made

1All statutory references are to the Internal Revenue Code of 1954 as in effect in the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure except as otherwise noted.

net section 482 adjustments of $2,359,331 for 1981 and $18,425,750 for 1982.

After concessions, the issues for determination are: (1) Whether respondent's allocations of gross income from Bausch & Lomb Ireland, Ltd., to Bausch & Lomb Inc. were arbitrary, capricious, or unreasonable; and (2) whether an allocation under section 482 is required to clearly reflect petitioners' income.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations and exhibits attached thereto are incorporated herein by this reference.

I. Introductory information

A. Petitioners

Petitioner Bausch & Lomb Inc. is a New York corporation with principal corporate offices at Rochester, New York, at the time its petition herein was filed. Unless otherwise indicated, as used herein, the term "B&L" shall refer to Bausch & Lomb Inc., as a separate and legal entity. B&L is the parent company of a group of corporations which filed consolidated Federal income tax returns for its tax years ending in 1979, 1980, 1981, and 1982. Unless otherwise indicated, as used herein, the term "petitioners" shall include B&L, as well as its subsidiaries which were included in the above-described consolidated Federal income tax returns. The term "B&L and its subsidiaries" shall refer to B&L and those of its subsidiaries and affiliates which are consolidated for financial reporting purposes, including foreign subsidiaries.

During the years 1979, 1980, 1981, and 1982, petitioners kept their books and records and filed their Federal income tax returns on the basis of an accrual method of accounting, and on the basis of a 52-53 week taxable year.

B. Bausch & Lomb Ireland, Ltd.

Bausch & Lomb Ireland, Ltd. (B&L Ireland), is a corporation organized and existing under the laws of the Republic of Ireland, with its principal place of business at Waterford,

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