Seagate Technology v. Commissioner

CONTENTS

Page

156 STATEMENT OF ISSUES .

157 I. GENERAL FINDINGS OF FACT

A. Background in General . ÜI <1

B. The Industry in General . ÜT CO

C. Seagate Scotts Valley. a lO t-H

D. Seagate Singapore. o CD tH

161 II. ISSUE 1: WHETHER RESPONDENT’S REALLOCATIONS OF GROSS INCOME UNDER SECTION 482 ARE ARBITRARY, CAPRICIOUS, AND UNREASONABLE.

161 A. FINDINGS OF FACT .

161 1. The Notices of Deficiency.

162 2. Respondent’s Expert Reports .

163 B. OPINION .

163 1. The Parties’ Positions .

163 2. Section 482 in General.

165 III. ISSUE 2: WHETHER RESPONDENT SHOULD BEAR THE BURDEN OF PROOF FOR ANY OF THE ISSUES INVOLVED IN THE INSTANT CASE .

165 A. FINDINGS OF FACT .

165 1. The Notices of Deficiency.

167 2. Respondent’s Concessions .

167 3. Respondent’s Experts .

168 B. OPINION .

168 1. The Parties’ Positions .

169 2. The Court’s Holding as to the Burden of Proof .

172 IV. ISSUE 3: WHETHER SEAGATE SCOTTS VALLEY PAID SEAGATE SINGAPORE ARM’S-LENGTH PRICES FOR COMPONENT PARTS.

172 A. FINDINGS OF FACT .

172 1. In General .

172 2. Intercompany Transactions .

173 3. Component Parts Manufacturing.

176 4. Respondent’s Notices of Deficiency .

176 5. Petitioner’s Experts .

176 a. Daniel P. Broadhurst.

177 b. Gary E. Holdren.

177 c. Clark J. Chandler .

181 6. Respondent’s Experts .

181 a. Thomas Horst.

182 b. Grant M. Clowery .

184 c. Steven M. Zemsky.

184 7. Other Third Party Transactions .

185 B. OPINION .

185 1. Ultimate Findings of Fact .

185 2. The Methods .

186 a. The Comparable Uncontrolled Price (CUP) Method.

186 i. The CUP Method in General .

ii. The Parties’ Positions on the CUP Method and the Court’s Holding as to Its Application. M 00 <1

b. The Cost-Plus Method . P-i OD GO

i. The Cost-Plus Method in General . J-i 00 00

189 ii. The Parties’ Positions on the Cost-Plus Method as Applied by Dr. Horst and the Court’s Ruling as to That Method.

193 iii. The Parties’ Positions on Applying the Cost-Plus Method Using the Bull Peripheriques Sale and the Court’s Holding as to That Method .

194 iv. The Parties’ Position on Applying the Cost-Plus Method Using Dr. Chandler’s Approaches and the Court’s Holding as to That Method .

195 c. The Court’s Holding as to the Arm’s-Length Transfer Price for Component Parts Sold to Seagate Scotts Valley.

196 V. ISSUE 4: WHETHER SEAGATE SCOTTS VALLEY PAID SEAGATE SINGAPORE AN ARM’S-LENGTH PRICE FOR COMPLETED DISK DRIVES SEAGATE SINGAPORE PRODUCED AND SOLD TO SEAGATE SCOTTS VALLEY .

196 A. FINDINGS OF FACT .

196 1. Disk Drive Manufacturing and Sales .

201 2. Respondent’s Notices of Deficiency .

203 3. Petitioner’s Experts .

203 a. Mr. Holdren.

213 b. Mr. Broadhurst .

217 4. Respondent’s Experts .

217 a. Dr. Clowery .

220 b. Dr. Frisch .

225 B. OPINION .

225 1. Ultimate Findings of Fact .

225 2. Analysis of Completed Disk Drive Issue .

226 a. The CUP Method .

226 i. Petitioner’s Position .

227 ii. Respondent’s Position .

228 iii. The Court’s Holding as to the CUP Method.

231 b. The Resale Price Method .

233 i. Respondent’s Resale Price Method .

235 ii. The Court’s Holding as to Respondent’s Resale Price Method.

236 iii. Petitioner’s Resale Price Method.

238 iv. The Court’s Holding as to Petitioner’s Resale Price Method.

238 c. The Court’s Holding as to the Arm’s-Length Transfer Prices for the Disk Drives .

d. The Price Allowance and Allowance for Seagate Singapore’s Marketing Activities Allowed by Respondent in the Notices of Deficiency . to o

i. The Price Allowance . w o

241 ii. The “Offset” for Seagate Singapore’s Marketing Activities .

VI. ISSUES 5 AND 6: WHETHER SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY ARM’S-LENGTH ROYALTIES FOR THE USE OF CERTAIN INTANGIBLES AND WHETHER THE ROYALTY FEE SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY FOR DISK DRIVES COVERED UNDER A SECTION 367 PRIVATE LETTER RULING APPLIES TO ALL SUCH DISK DRIVES SHIPPED TO THE UNITED STATES, REGARDLESS OF WHERE TITLE PASSED . 241

A. FINDINGS OF FACT . 242

1. General Background Information . 242

2. Seagate Scotts Valley and Seagate Singapore Agreements . 243

a. The Property Transfer Agreement . 243

b. The Royalty Agreement. 245

c. The Marketing Agreement . 246

3. The Ruling Request and Private Letter Ruling. 247

a. The Request . 247

b. The Private Letter Ruling. 248

4. Royalties Paid . 249

5. Third Party Licensing Agreements . 249

a. Co. R and Co. S . 249

b. Texas Instruments, Inc. 250

c. Honeywell Bull . 251

d. TEAC Corp . 251

e. Co. K . 252

f. Co. L . 252

g. Co. M. 253

h. IBM. 253

i. Co. N.■.. 253

j. Co. B and Co. C Agreement. 254

k. LaPine Technology Corp. and Kyocera Corp. Agreements ... 255

i. The Research and Development Agreement . 256

ii. The Trading Agreement . 256

iii. The Technology Transfer and Manufacturing Agreement . 257

l. Co. B and Co. F Agreement . 258

m. Co. P and Co. Q Agreement. 259

n. Co. D and Co. E Agreement. 259

o. Co. G and Cos. H and J Agreement . 260

6. Respondent’s Notices of Deficiency . 261

7. The Experts’ Positions . 262

a. Petitioner’s Experts . 262

i. Dr. Chandler. 262

ii. James Patterson . 263

iii. Zoltán M. Mihaly . 264

iv. Paul M. Enlow. 265

v. Mr. Holdren . 265

vi. Mr. Broadhurst. 266

b. Respondent’s Experts . 266

i. Dr. Horst. 266

268 ii. Anthony Larme .

270 iii. Mark R. Sherwood .

271 iv. Harold J. McLaughlin.

271 v. George E. Frost .

273 B. OPINION ...

273 1. Analysis of Arm’s-Length Royalties for Use of Intangibles .

273 a. The Regulations in General .

274 b. The Parties’ Positions .

274 i. Respondent’s Position .

275 ii. Petitioner’s Position .

278 c. The Court’s Holding as to the Arm’s-Length Royalty Rate ..

d. The Offset for the Marketing Commissions Paid by Seagate Singapore to Seagate Scotts Valley . to CO to

2. Analysis of Scope of Ruling . to 00 ^

289 VII. ISSUE 7: WHETHER THE PROCUREMENT SERVICES FEES SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY WERE ARM’S LENGTH.

290 A. FINDINGS OF FACT .

290 1. Background .

290 a. The Services Agreement.

29] b. Procurement Services Performed by Seagate Scotts Valley for Seagate Singapore .

292 c. Seagate Singapore’s Procurement Activities.

293 d. Solarise Enterprises, Inc .

294 2. Respondent’s Notices of Deficiency .

295 3. The Experts’ Positions .

295 a. Petitioner’s Expert — Dr. Chandler .

296 b. Respondent’s Experts .

296 i. Martin Ehrlich .

297 ii. Dr. Clowery .

298 B. OPINION .

298 1. The Burden of Proof.

299 2. The Services Regulations.

301 3. The Parties’ Positions .

301 a. Petitioner’s Position.

303 b. Respondent’s Position.

303 c. The Court’s Holding as to the Arm’s-Length Procurement Services Fee .

305 VIII. ISSUE 8: WHETHER THE CONSIDERATION SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY PURSUANT TO A COST-SHARING AGREEMENT WAS ARM’S LENGTH .

305 A. FINDINGS OF FACT .

305 1. Background .

306 2. The Research and Development Cost-Sharing Agreement .

306 3. Payments Under the Cost-Sharing Agreement .

307 4. The Experts’ Opinions.

307 a. Petitioner’s Expert — Dr. Chandler .

309 b. Respondent’s Experts .

i. Dr. Horst. 05 O CO

ii. Dr. Clowery .¡. 05 O CO

310 iii. Dr. Chandler’s Critique of Dr. Horst’s and Dr. Clowery’s Method.

311 B. OPINION .

311 1. The Cost-Sharing Regulations .

311 2. The Parties’ Positions .

311 a. Petitioner’s Position.

312 b. Respondent’s Position.

312 3. The Court’s Holding as to the Arm’s-Length Share of the Research and Development Costs

IX. ISSUE 9: WHETHER SEAGATE SCOTTS VALLEY IS ENTITLED TO OFFSETS FOR WARRANTY PAYMENTS SEAGATE SINGAPORE PAID TO SEAGATE SCOTTS VALLEY . 314

A. FINDINGS OF FACT . 314

1. Background . 314

2. Respondent’s Notices of Deficiency . 315

B. OPINION . 315

1. The Parties’ Positions . 315

a. Petitioner’s Position. 315

b. Respondent’s Position. 316

2. The Court’s Holding as to the Warranty Offset. 316

317 X. PROCEDURAL MATTERS .

317 A. Petitioner’s Motion To Exclude Part IV of Dr. Clowery’s Report

317 1. Background .

2. Ruling on Exclusion of Part IV of Dr. Clowery’s Report . 00 to o

B. Petitioner’s Motion To Exclude Certain Documents . CO to K-l

Wells, Judge: Respondent determined deficiencies in petitioner’s consolidated corporate Federal income tax as shown by the following chart:

TYE Deficiency

June 30, 1981 $85,826

June 30, 1983 51,510

June 30, 1984 23,483,054

June 30, 1985 73,420

June 30, 1986 12,801,009

June 30, 1987 75,785,217

All section references are to the Internal Revenue Code of 1954 as amended and in effect for the years in issue unless otherwise indicated. All Rule references are to the Tax Court Rules of Practice and Procedure unless otherwise indicated.

STATEMENT OF ISSUES

In the instant case, we are asked to decide several distinct transfer pricing issues arising out of adjustments determined by respondent under section 482. Following concessions by the parties, the issues for decision are as follows:

1. Whether respondent’s reallocations of gross income under section 482 for the years in issue are arbitrary, capricious, or unreasonable;

2. whether respondent should bear the burden of proof for any of the issues involved in the instant case;

3. whether petitioner Seagate Technology, Inc. (hereinafter referred to as Seagate Scotts Valley), paid Seagate Technology Singapore, Pte. Ltd. (Seagate Singapore), a wholly owned subsidiary of Seagate Scotts Valley, arm’s-length prices for component parts;

4. whether Seagate Scotts Valley paid Seagate Singapore arm’s-length prices for completed disk drives;

5. whether Seagate Singapore paid Seagate Scotts Valley arm’s-length royalties for the use of certain intangibles;

6. whether the royalty fee Seagate Singapore paid Seagate Scotts Valley for disk drives covered under a section 367 private letter ruling applies to all such disk drives shipped to the United States, regardless of where title passed;

7. whether the procurement services fees Seagate Singapore paid Seagate Scotts Valley were arm’s length;

8. whether the consideration Seagate Singapore paid Seagate Scotts Valley pursuant to a cost-sharing agreement was arm’s length; and

9. whether Seagate Scotts Valley is entitled to offsets for warranty payments Seagate Singapore paid to Seagate Scotts Valley.

Because the various discrete issues involved in the instant case are quite complex, for convenience and clarity, we have divided our opinion into separate segments. The first segment sets forth general facts applicable to all of the issues. Each of the segments following our general findings sets forth our findings of fact and opinion as to a separate discrete issue set forth above, except that issues 5 and 6 are combined into one segment.

I. GENERAL FINDINGS OF FACT

Some of the facts and certain documents have been stipulated for trial pursuant to Rule 91. We incorporate the stipulated facts herein by reference.

A. Background in General

Seagate Scotts Valley is a corporation organized under the laws of California with its principal offices in Scotts Valley, California. Seagate Scotts Valley maintains its books and records on an accrual basis and filed its Federal tax returns for the years ended June 30, 1981, 1982, 1983, 1984, 1985, 1986, and 1987 (the years in issue), accordingly.

Seagate Scotts Valley’s stock is publicly traded on the New York Stock Exchange. Seagate Scotts Valley is the parent corporation of the affiliated group of corporations described below.

Seagate Singapore was organized under the laws of the Republic of Singapore (Singapore) in July 1982, and has its principal office in Singapore. Seagate Singapore assembles and manufactures disk drives and disk drive components.

Seagate Technology (Thailand), Ltd. (Seagate Thailand), was incorporated in Thailand on or about October 7, 1983, to assemble disk drive components, including E-blocks and head assemblies.

Seagate Technology GmbH (Seagate Germany) was incorporated in Germany on or about February 10, 1984, primarily to market disk drives to Seagate Scotts Valley’s European-based customers.

Seagate Technology International (Seagate Cayman Islands) was incorporated in the Cayman Islands on or about May 14, 1984, but was inactive during the years in issue.

Seagate Technology Scotland, Ltd. (Seagate Scotland), was incorporated in Scotland on or about January 22, 1985, to service, test, and repair Seagate Scotts Valley’s disk drives and related components.

Seagate Technology Japan, Ltd. (Seagate Japan), was incorporated in Japan on or about March 1985, to procure materials on behalf of Seagate Scotts Valley’s manufacturing facilities.

Seagate Magnetics (SeaMag), formerly known as Grenex, Inc., was acquired by Seagate Scotts Valley during 1985. SeaMag is a U.S. manufacturer of disks used in disk drives.

B. The Industry in General

Computers use auxiliary memory systems, such as disk drives, to record, store, and retrieve information because their semiconductor memories generally cannot store all of the information needed for the computer’s applications. The floppy disk drive and the hard disk drive are the two main types of disk drives. The amount of information that a hard disk can store is measured in megabytes (1 million bytes). The higher the number of megabytes that a hard disk can store, the greater is its storage capacity. The hard disk drive industry constantly produces products with greater capacity. The disk drive industry is characterized by intense competition and declining prices.

Major components of a hard disk drive include the disk, which stores the information; the heads, which read and write the information on the disk; the spindle motor, which rotates the disk; the circuit boards, which control the mechanical operation of the drive; the actuator system, which positions the heads over the disks; the stepper or voice coil motor, which moves the actuator system; and the circuit boards, which serve as an interface for the transfer of information between the disk drive and the central processing unit of the computer.

During the 1960s, the International Business Machines Corp. (IBM) produced a hard disk drive that could store 30 megabytes of information on a removable hard disk and 30 megabytes of information on a fixed hard disk, which became known as a “Winchester drive” (referring to the Winchester 30-30 rifle) because it used two disks which each held 30 megabytes of information. The term “Winchester drive” is now sometimes used to refer to most types of hard disk drives.

Manufacturers of hard disk drives for personal computers design their disk drives so that the hard disk drive has the same form factor (e.g., exterior dimensions) as the floppy disk drive in the computer. The most common form factor for personal computers is the 5.25-inch full height and the 5.25-inch half height.

IBM compatible computer systems are designed to accommodate industry standards. As a result of industry standardization, manufacturers of computer systems are able to use disk drives from a number of manufacturers in any given computer system. Original equipment manufacturers (OEM’s) sometimes purchase disk drives from more than one vendor simultaneously. IBM, for example, purchases disk drives for its XT personal computer from Seagate Scotts Valley and Miniscribe Corp. simultaneously.

C. Seagate Scotts Valley

Seagate Scotts Valley designs, develops, manufactures, and markets a line of Winchester technology magnetic hard disk drives for use in computer systems. Seagate Scotts Valley is one of the world’s leading manufacturers of hard disk drives. The most common application for Seagate Scotts Valley’s products is in personal computer systems. Disk drives sold by Seagate Scotts Valley can be used in various IBM compatible computer systems.

Seagate Scotts Valley introduced its first disk drive, the ST506, during July 1980. The ST506 is the first 5.25-inch hard disk drive. It has a five-megabyte formatted capacity. Seagate Scotts Valley develops, designs, manufactures, and markets the ST506 disk drive. Seagate Scotts Valley continues to design and develop new disk drives with higher capacity and faster access time.

Seagate Scotts Valley sells 15 models of hard disk drives, including the ST212, ST225, and ST412. The ST225 is Seagate Scotts Valley’s biggest seller.

In addition to disk drive system development and manufacture, Seagate Scotts Valley also develops and manufactures disk drive components.

The design drawings for Seagate Scotts Valley’s disk drives and for the components of the disk drives that are made to Seagate Scotts Valley’s specifications, are proprietary. Seagate Singapore acquired some of such proprietary information from Seagate Scotts Valley through property transfers during 1983 and 1984 and as a result of a cost-sharing agreement.

Other companies sell hard disk drives of a similar size and capacity that compete with the disk drives Seagate Scotts Valley sells, except during Seagate Scotts Valley’s fiscal year ended June 30, 1981. Some OEM’s, such as IBM, also manufacture disk drives for their own uses.

D. Seagate Singapore

Seagate Scotts Valley conducted all of its manufacturing activities in Scotts Valley, California, and Watsonville, California, prior to the time Seagate Singapore was formed.

During July 1982, David T. Mitchell (Mr. Mitchell), a cofounder of Shugart Technology, Seagate Scotts Valley’s predecessor company, 1 and at the time Seagate Scotts Valley’s vice president of operations, traveled to Hong Kong and Singapore to locate prospective sites for an offshore purchasing office. After discussions with the Economic Development Board of Singapore and Sing Cheong Tien (Mr. Tien), Mr. Mitchell concluded that some component manufacturing also could be performed in Singapore. Seagate Singapore was incorporated on July 30, 1982, for the purpose of performing such manufacturing.

Mr. Mitchell hired Mr. Tien to organize and oversee all of Seagate Singapore’s operations. Mr. Tien assembled his core managerial staff from contacts he had established and developed while in Singapore.

On August 12, 1983, the Economic Development Board approved Seagate Singapore’s application for certain investment incentives, including exemption from Singapore taxation, and granted tax relief to Seagate Singapore for 10 years commencing from October 1, 1982.

During October 1983, Seagate Scotts Valley began moving some of its disk drive manufacturing operations to Seagate Singapore to take advantage of Singapore’s large, qualified labor supply. Seagate Scotts Valley’s management believed that the transfer of disk drive manufacturing to Singapore would help Seagate Scotts Valley remain competitive in the disk drive market by reducing product costs and would help it capture a share of the growing market for disk drives in East Asia. As Seagate Singapore was a wholly owned subsidiary of Seagate Scotts Valley, significant decisions of Seagate Singapore required Seagate Scotts Valley’s approval.

Seagate Singapore’s disk drive manufacturing operations grew rapidly, selling the following volume of disk drives:

Year Volume

1984 . 125,919

1985 . 568,753

1986 . 1,397,823

1987 . 3,413,463

Starting with approximately 50 employees in November 1982, by 1987, Seagate Singapore grew into the second largest employer in Singapore, employing 8,067 people. By attracting qualified workers at wages that were at the lower end of wages prevailing in Singapore, Seagate Singapore’s management was able to control labor costs. •

II. ISSUE 1

Whether respondent’s reallocations of gross income under section 482 are arbitrary, capricious, and unreasonable.

A. FINDINGS OF FACT

1. The Notices of Deficiency

In the notices of deficiency, respondent reallocated income from Seagate Singapore to Seagate Scotts Valley in the following amounts:

Period ended Sec. 482 reallocation

6/30/83 . $3,962,000

6/30/84 . 20,963,000

6/30/85 . 30,320,000

6/30/86 . 78,353,000

6/30/87 . 151,798,000

Total 285,396,000

2. Respondent’s Expert Reports

As reflected in respondent’s expert reports introduced at trial, the total adjustments are as follows:

Period ended Sec. 482 reallocation

6/30/83 . $1,710,547

6/30/84 . 7,923,957

6/30/85 . 1 30,405,674

6/30/86 . 67,019,354

6/30/87 . 2 64,324,329

Total . 171,383,861

The adjustments in the reports of respondent’s experts relate to reallocations for the resale margin that Seagate Scotts Valley allegedly should have earned at arm’s length for distributing Seagate Singapore-produced disk drives; reallocations for the royalty income that Seagate Scotts Valley should have earned at arm’s length for designing, transferring, and significantly contributing to the manufacturing of products developed from disk drive technology, developing a customer base for Seagate Singapore, and for the use by Seagate Singapore of Seagate Scotts Valley’s name and corporate reputation; reallocations for the sharing of costs between Seagate Singapore and Seagate Scotts Valley relating to the development of disk drive technology after January 1, 1985; reallocations for procurement fees Seagate Singapore should have paid at arm’s length to Seagate Scotts Valley to compensate Seagate Scotts Valley for, among other functions, qualifying vendors, performing first article inspection, acquiring materials, inventorying materials, and selling the materials to Seagate Singapore; and reallocations from Seagate Singapore to Seagate Scotts Valley relating to printed circuit board and E-block assembly.

B. OPINION

1. The Parties’ Positions

Petitioner contends that its transactions with Seagate Singapore were conducted at arm’s length. Petitioner offered evidence at trial, including expert testimony, to support its position that respondent’s adjustments are arbitrary, capricious, or unreasonable.

On the other hand, respondent argues that the adjustments contained in the notice of deficiency are not arbitrary, capricious, or unreasonable. At trial, respondent also offered evidence, including expert testimony, in support of the Government’s position.

2. Section 482 in General

Section 482 2 gives respondent broad authority to allocate income, deductions, credits, or allowances between commonly controlled organizations, trades, or businesses if respondent determines that the reallocation is necessary to prevent the evasion of taxes or clearly to reflect the income of the controlled entities. The purpose of section 482 is to prevent the artificial shifting of the net incomes of controlled taxpayers by placing controlled taxpayers on a parity with uncontrolled, unrelated taxpayers. Sundstrand Corp. v. Commissioner, 96 T.C. 226, 352-353 (1991); see also Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 581 (1989), affd. 933 F.2d 1084 (2d Cir. 1991); Edwards v. Commissioner, 67 T.C. 224, 230 (1976); sec. 1.482-1(b)(1), Income Tax Regs.

The income tax regulations set forth an arm’s-length standard to determine whether reallocations between controlled entities are necessary. To make such a determination, the regulations attempt to identify the “true taxable income” of each entity based on the taxable income which would have resulted had the entities been uncontrolled parties dealing at arm’s length. See Sundstrand Corp. v. Commissioner, supra at 353; sec. 1.482 — 1(b)(1), Income Tax Regs.

The Commissioner’s determination as set forth in a notice of deficiency is presumptively correct. The taxpayer has the burden of disproving that determination. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). Absent a showing of abuse of discretion by the Commissioner, the Commissioner’s section 482 determination must be sustained. Bausch & Lomb, Inc. v. Commissioner, supra at 582. To succeed, therefore, a taxpayer first must show that the Commissioner’s section 482 reallocations are arbitrary, capricious, or unreasonable. Sundstrand Corp. v. Commissioner, supra; Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1131 (1985), affd. in part, revd. in part, and remanded 856 F.2d 855 (7th Cir. 1988). In deciding whether the Commissioner’s determination is reasonable, the Court focuses on the reasonableness of the result, not on the details of the methodology used. Bausch & Lomb, Inc. v. Commissioner, supra; see also Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 676 , 372 F.2d 990, 997 (1967).

In addition to proving that the deficiencies set forth in the notice of deficiency are arbitrary, capricious, or unreasonable, the taxpayer has the burden of proving satisfaction of the arm’s-length standard. See Eli Lilly & Co. v. Commissioner, 856 F.2d at 860 ; Sundstrand Corp. v. Commissioner, supra at 354.

If the Commissioner proposes a reallocation under section 482 with respect to an item or transaction, the taxpayer may claim a setoff with respect to another item or transaction between the same parties in the same year if the taxpayer can show that the reallocation with respect to that item or transaction is appropriate. Sundstrand Corp. v. Commissioner, supra; sec. 1.482-1(d)(3), Income Tax Regs.; Rev. Proc. 70-8, 1970- 1 C.B. 434 .

In the instant case, respondent’s reallocations at least must be reasonable attempts to reflect arm’s-length transactions between Seagate Scotts Valley and Seagate Singapore. See Achiro v. Commissioner, 77 T.C. 881, 900 (1981). For the reasons set forth infra, we conclude that respondent’s reallocations are arbitrary, capricious, and unreasonable.

III. ISSUE 2

Whether respondent should bear the burden of proof for any of the issues involved in the instant case.

A. FINDINGS OF FACT

1. The Notices of Deficiency

The Form 4549-B (Income Tax Examination Changes) attached to the notice of deficiency for Seagate Scotts Valley’s fiscal year ended June 30, 1986, shows an adjustment titled “section 482 adjustment” for that year in the amount of $78,353,000. In the Explanation of Items attached to the notice of deficiency for the fiscal year ended June 30, 1986, respondent states in pertinent part the following relating to the section 482 reallocations:

l.a.N. (A) It is determined that * * * [Seagate Scotts Valley] transferred parts and components to * * * [Seagate Singapore] for use in the assembly of disk drives at less than arms’s length prices. Accordingly, under I.R.C. Section 482, gross income in the amount * * * [of $6,833,000 is allocated to Seagate Scotts Valley from Seagate Singapore].

The above amount was computed as shown on the attached schedule A. In the alternative, should the above determination not be upheld, it is determined that * * * [Seagate Scotts Valley] performed services for, or on behalf of, Seagate Singapore in procuring, processing, storing, and transferring parts and components for, or on behalf of, Seagate Singapore. It is further determined under I.R.C. section 482 that $6,833,000 is an arm’s-length charge for such services.

In the further alternative, should the above determinations not be upheld, it is determined under I.R.C. section 482 that an amount equal to the costs or deductions incurred during the 1986 fiscal year for the above services is allocated to * * * [Seagate Scotts Valley] from Seagate Singapore.

(B) It is determined that you have failed to substantiate adequately the existence of the following facts, among others, offered in support of your contention that * * * [Seagate Scotts Valley] and Seagate Singapore were operating at arm’s length during the fiscal year 1986:

(1) That patents, sales contracts and all of the other items of intangible property described in the undated document entitled “Property Transfer Agreement” were transferred to Seagate Singapore from * * * [Seagate Scotts Valley]. And further, if such intangible property was transferred, that it was transferred as of September 30, 1983, as alleged in the undated document entitled “Property Transfer Agreement”;

(2) That the undated document entitled “Research and Development Cost-sharing Agreement” is bona fide under the standards of Treas. Regulation Section 1.482 — 2(d)(4). And further, if the Research and Development Cost-sharing Agreement is bona fide, that Seagate Singapore was granted the right to sell products either directly, or indirectly through * * * [Seagate Scotts Valley], into the geographic area allocated to * * * [Seagate Scotts Valley].

(3) That during the fiscal year 1986 Seagate Singapore should be treated as having engaged in sales outside of the United States for purposes of the February 27, 1985 Section 367 Ruling or for purposes of analyzing functions, risks and intangibles under I.R.C. section 482; and

(4) That expenses relating to manufacturing, purchasing, quality assurance, warranty, general and administrative, research and development, marketing and sales were shared by * * * [Seagate Scotts Valley] and Seagate Singapore on an arm’s-length basis.

Accordingly, considering the functions performed, intangibles used and developed, services received and risks incurred, * * * [$71,520,000 is allocated under section 482 to Seagate Scotts Valley from Seagate Singapore as shown on attached schedules B-l through B-4].

(C) In the alternative, should the determinations in paragraphs (B)(1) and (B)(3) above relating to the absence of adequate substantiation as to the transfer of manufacturing intangibles and as to sales outside of the United States not be upheld, it is determined that the allocation adjustment amount shown in paragraph (B) above is reduced by * * * [$6,511,000 as shown on attached schedule C].

The allocations in the preceding paragraphs are based upon an analysis of respective functions performed, intangibles used and developed, services performed and received and risks incurred. Further, as an independent basis for the determination, an analysis of comparative profit, expenses incurred and financial returns of both * * * [Seagate Scotts Valley] and Seagate Singapore was performed.

The applicable section of the Form 4549-B and coinciding pertinent explanatory paragraphs contained in the Explanation of Items attached to the notice of deficiency for the fiscal years ended 1983, 1984, 1985, and 1987, are worded substantially the same except for the dates and amounts.

The Schedules A and B-l attached to the explanation of items for the notices of deficiency for the years in issue show the calculation for the total section 482 adjustments for each year in issue as follows (000’s omitted):

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2. Respondent’s Concessions

Before trial, respondent conceded the marketing services reallocation encompassed within the marketing services and intangibles adjustments detailed above. The marketing services reallocation represents the arm’s-length charge respondent calculated for marketing and sales support services Seagate Scotts Valley provided to Seagate Singapore for third party sales made by Seagate Singapore. As a result of conceding the marketing services reallocation, respondent also eliminated an offset which had been allowed in the notices of deficiency for marketing commissions Seagate Singapore paid to Seagate Scotts Valley.

3. Respondent’s Experts

A breakdown of the section 482 reallocations as concluded by respondent’s experts is as follows:

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The net increases and decreases in the section 482 adjustments as summarized by one of respondent’s experts, and as revised to reflect respondent’s concession for the 1985 resale margin adjustment, from the section 482 adjustments as detailed in the notices of deficiency are as follows:

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B. OPINION

1. The Parties’ Positions

Petitioner contends that the burden of proof should shift to respondent because, at trial, respondent proposed specific adjustment amounts for each issue that were substantially different from the specific amounts for such issues detailed in the notices of deficiency; denied offsets allowed in the notices; and ignored respondent’s own determination that the adjustment amounts should be reduced by certain amounts described in the notices of deficiency as reductions in the event respondent’s position on the validity of the section 367 private letter ruling did not prevail. Accordingly, petitioner posits, in effect, that respondent has abandoned the notices of deficiency and, as a result, respondent should bear the burden of proof for the entire case. Petitioner argues alternatively that, at a minimum, respondent should bear the burden of proof as to each specific adjustment which has been increased for any year whether or not the net deficiency has been decreased for that year.

Respondent counters that the notices of deficiency contain an aggregate, not separate, section 482 reallocation for each year. Respondent contends that, under Rule 142(a), the burden of proof is on respondent only as to “increases in deficiency”. According to respondent, as a result of the Government’s concession for the 1985 year, see supra, there is no increased deficiency for any year in the instant case; accordingly, respondent should not be required to bear the burden of proof for any issue.

2. The Court’s Holding as to the Burden of Proof

Generally, petitioner bears the burden of proof. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). Respondent, however, bears the burden of proof as to “any new matter, increases in deficiency, and affirmative defenses, pleaded in the answer”. Rule 142(a). A new position taken by respondent is not necessarily a “new matter” if it merely clarifies or develops respondent’s original determination without requiring the presentation of different evidence, being inconsistent with respondent’s original determination, or increasing the amount of the deficiency. Achiro v. Commissioner, 77 T.C. 881, 889-891 (1981); see also Yamaha Motor Corp., U.SA. v. Commissioner, T.C. Memo. 1992-110 ; Stewart v. Commissioner, T.C. Memo. 1982-209 , affd. 714 F.2d 977 (9th Cir. 1983).

Although petitioner contends that respondent has increased the deficiency within the meaning of Rule 142, petitioner has presented no calculations which establish that the deficiency for any year in issue has increased. 3 Respondent, furthermore, has not asserted any claim for an increase in deficiency by amended answer or otherwise for any year in issue. See sec. 6214(a). Petitioner’s arguments regarding burden of proof focus on changes in the amounts of individual items which respondent details in Schedules A and B of the Explanation of Items attached to the notices of deficiency. Petitioner’s position is premised on the theory that each item described in Schedules A and B of the Explanation of Items is a separate, independent section 482 adjustment and that, because respondent’s trial position results in changes to the dollar amounts of such separately detailed reallocations, respondent must bear the burden of proof for the entire case. We do not agree.

For purposes of deciding the taxable income which Seagate Scotts Valley and Seagate Singapore derived from the design, manufacture, and sale of disk drives and component parts, we believe that the transfer prices for the disk drives and component parts sold, the royalty rates for the intangibles transferred, and the value of the services rendered, must be accorded independent consideration. See Bausch & Lomb, Inc. v. Commissioner, 933 F.2d 1084, 1088 (2d Cir. 1991), affg. 92 T.C. 525 (1989). That is not to say, however, that, for purposes of deciding who has the burden of proof, under the circumstances present in the instant case, respondent’s methodology did not result in one aggregate section 482 adjustment. To the contrary, we conclude that respondent did make only one aggregate section 482 adjustment in the instant case. 4

All of the items in dispute relate to the business relationship between Seagate Scotts Valley and Seagate Singapore pertaining to the design, manufacture, and sale of disk drives or component parts for disk drives. Moreover, respondent’s methodologies in computing arm’s-length transfer prices, royalty rates, and procurement fees relating to the disk drives and component parts are interconnected. For example, the method used in the notices of deficiency for calculating the total value of manufacturing intangibles, which we discuss infra, computed the value of manufacturing intangibles as a residual. Consequently, the amounts for manufacturing intangibles set forth in the notices of deficiency depend upon the level of the other section 482 adjustments. From our review of the record as a whole, in determining the aggregate section 482 adjustment for each year in issue, we believe that respondent considered each individual reallocation as merely a part of the whole.

Although respondent’s trial position revises the amounts of the separately detailed reallocations, the record contains no evidence of an increase in deficiency for any year in issue. Changes to the dollar amounts of the individual reallocations do not result in a net increase in the section 482 reallocations. Rather, respondent’s concessions relating to some of the individual section 482 reallocations result in a net decrease in the aggregate section 482 adjustment for each year. Consequently, petitioner has not shown an increase in deficiency for any year for which respondent must bear the burden of proof.

Rule 142(a) states that, absent the assertion of an affirmative defense or an increase in deficiency, the burden of proof for the issues involved in the instant case is on respondent only if respondent introduces a “new matter”. Petitioner argues that respondent’s concessions as to individual reallocations set forth in the notices of deficiency alter the original deficiencies and, consequently, respondent has introduced a new matter for which respondent must bear the burden of proof. See Achiro v. Commissioner, supra at 890. We have found no case holding that a change in the dollar amount of a separately detailed reallocation specified in the notice of deficiency, by itself, shifts the burden of proof to respondent. Rather, numerous cases have held to the contrary. See Yamaha Motor Corp., U.S.A. v. Commissioner, T.C. Memo. 1992-110 ; Forte v. Commissioner, T.C. Memo. 1991—36; National Oil Co. v. Commissioner, T.C. Memo. 1986-596 ; cf. McSpadden v. Commissioner, 50 T.C. 478 , 492—493 (1968); Catty v. Commissioner, T.C. Memo. 1983-203 ; Stewart v. Commissioner, T.C. Memo. 1982-209 , affd. 714 F.2d 977 (9th Cir. 1983); Dees v. Commissioner, T.C. Memo. 1962-153 .

Similarly, we do not conclude that petitioner has been unfairly prejudiced by concessions respondent made in the light of information respondent obtained during preparation for trial. See National Oil Co. v. Commissioner, T.C. Memo. 1986-596 . Indeed, to the extent of a reduction in a separately detailed section 482 reallocation, petitioner is relieved of the burden of proving that respondent’s determination as to those excess amounts was erroneous. See Gobins v. Commissioner, 18 T.C. 1159, 1168-1169 (1952), affd. per curiam 217 F.2d 952 (9th Cir. 1954); Kim v. Commissioner, T.C. Memo. 1991-500 .

Accordingly, we hold that respondent does not bear the burden of proof for matters in issue in the instant case merely because respondent made revisions at trial to the separately detailed section 482 reallocations contained in the notices of deficiency. Whether respondent’s change in position as to a specific separately detailed item for a year in issue represents the assertion of a new matter for that item, will be addressed, if appropriate, separately in the applicable segment below along with the resulting effect such a change has, if any, on the burden of proof.

IV. ISSUE 3

Whether Seagate Scotts Valley paid Seagate Singapore arm’s-length prices for component parts.

A. FINDINGS OF FACT

1. In General

Prior to 1982, Seagate Scotts Valley manufactured disk drives and certain component parts for disk drives, such as E-blocks, solely in the United States. During 1982, Seagate Scotts Valley formed Seagate Singapore to manufacture E-blocks and printed circuit boards (PCB’s) for Seagate Scotts Valley’s use in the manufacture of disk drives.

Prior to forming Seagate Singapore, Seagate Scotts Valley employed third parties to incorporate integrated circuits on PCB’s that Seagate Scotts Valley then used in its disk drives. With respect to other disk drive component parts, such as motors, Seagate Scotts Valley purchased the completed component parts from vendors who independently purchased all the materials needed to manufacture the component parts.

2. Intercompany Transactions

Seagate Singapore began selling component parts for disk drives to Seagate Scotts Valley in the taxable year ended June 30, 1983, and began selling disk drives to Seagate Scotts Valley in the taxable year ended June 30, 1984.

Initially, Seagate Scotts Valley used its standard cost of manufacturing the component parts or completed disk drives in the United States as the transfer price of the completed disk drives and component parts Seagate Singapore sold to Seagate Scotts Valley. Sometime later, Seagate Scotts Valley changed the transfer price to the standard cost of manufacturing the component part or disk drive in Singapore plus 25 percent of those costs. Seagate Singapore included an estimate for scrap and obsolescence costs in the costs that were marked up as part of the cost plus 25-percent transfer pricing methodology. The prices Seagate Singapore charged Seagate Scotts Valley for component parts and disk drives were not adjusted for variations between actual costs and standard costs.

Under both the initial transfer price system and the revised transfer price system, Seagate Scotts Valley occasionally reviewed the standard costs of manufacturing component parts and disk drives, and adjusted the transfer prices if the standard costs had changed. Seagate Scotts Valley sometimes retroactively reduced the transfer prices Seagate Singapore charged Seagate Scotts Valley to reflect lower standard costs or to correct errors. Seagate Scotts Valley did not reduce the transfer prices for Seagate Singapore-produced disk drives or component parts in response to reductions in the prices Seagate Scotts Valley charged third parties for the disk drives.

3. Component Parts Manufacturing

During all of the years in issue, Seagate Singapore sold component parts, most of which were printed circuit boards (pcb’s), E-blocks, or head gimbel assemblies (hga’s).

Seagate Scotts Valley designed the circuit board layout of the raw pcb’s Seagate Singapore used in its PCB assembly process. Seagate Scotts Valley also developed the ROM chips that Seagate Singapore “stuffed” into the circuit boards.

Initially, Seagate Singapore’s operations consisted of assembling E-blocks and testing pcb’s assembled for Seagate Singapore by local subcontractors. Seagate Singapore also put PCB materials into kits for the local subcontractors. Seagate Singapore began assembling pcb’s at its own PCB facility sometime during 1984.

Seagate Singapore began shipping 500 pcb’s per day during 1983. By 1987, Seagate Singapore’s PCB operation employed nearly 1,800 people, including nearly 300 engineers, and produced 22,000 pcb’s per day in four separate buildings housing approximately 100,000 square feet. Seagate Singapore eventually became the largest manufacturer in Singapore of pcb’s for computer peripheral devices.

Seagate Singapore purchased from third parties some of the materials it used to manufacture component parts. At times, Seagate Singapore subcontracted to local subcontractors PCB assembly work which, for various reasons, Seagate Singapore could not handle at its PCB facilities. The PCB’s Seagate Singapore subcontracted out generally were established, simpler boards. The local PCB subcontractors were smaller and performed less sophisticated operations than Seagate Singapore.

Seagate Singapore consigned materials to the PCB subcontractors. It paid the subcontractors a fixed per-board rate which was based on the subcontractors’ labor costs plus margin. During 1982 through 1985, Seagate Singapore paid per-board rates ranging between $6 and $8. During 1986 and 1987, Seagate Singapore paid per-board rates ranging between $5 and $6. The subcontractors generally marked up their labor costs between 8 and 10 percent.

During or near October 1983, Seagate Singapore began purchasing E-block assemblies from Seagate Thailand. During early 1984, Seagate Thailand also began assembling hga’s for Seagate Singapore. During January 1985, Seagate Singapore contracted with an unrelated company to assemble HGA subassemblies in the Philippines. Seagate Singapore consigned all direct materials to that subcontractor. Seagate Singapore agreed, among other things, to reimburse the HGA subcontractor for its labor costs at specified rates. Seagate Thailand and Seagate Singapore jointly provided support functions for the Philippine subcontractor.

On June 10, 1986, Seagate Singapore entered into an assembly contract agreement with an unrelated party for the assembly in South Korea of HGA’s for certain disk drive models manufactured by Seagate Singapore. Seagate Singapore supplied the materials to that subcontractor.

Seagate Singapore incurred the costs of financing its purchases of materials used in manufacturing component parts. When Seagate Scotts Valley purchased materials for Seagate Singapore, Seagate Scotts Valley incurred the cost of financing until Seagate Singapore paid for the materials.

Although Seagate Singapore sold most of the component parts it manufactured to Seagate Scotts Valley, it also sold some component parts to unrelated parties in the fiscal years ended June 30, 1985, 1986, and 1987. Those sales represented less than 0.5 percent of Seagate Singapore’s component parts sales in 1985 and 1986 and less than 4 percent of such sales in 1987. Seagate Singapore also used some of the component parts internally for Seagate Singapore-produced disk drives.

Seagate Singapore made gross sales of component parts to Seagate Scotts Valley in approximately the following amounts:

Period ended Amount

June 30, 1983 $26,000,000

June 30, 1984 77,000,000

June 30, 1985 31,000,000

June 30, 1986 40,000,000

June 30, 1987 26,000,000

Seagate Singapore’s gross profit as a percentage of sales of component parts and its gross profit as a percentage of cost of sales of component parts were approximately as follows:

Period ended Gross profit as a percent of sales Gross profit as a percent of cost of sales

June 30, 1983 17.6% 21.39%

June 30, 1984 18.4 22.57

June 30, 1985 16.6 19.86

June 30, 1986 22.0 28.33

June 30, 1987 8.7 9.51

During its fiscal year ended 1985, Seagate Scotts Valley entered into an agreement with Bull Peripheriques, an unrelated party, for the sale of certain subassemblies at a unit price of U.S. $87.40, for a yearly quantity of 10,000 to 20,000 units. On July 24, 1984, Seagate Singapore sold to Bull Peripheriques 480 each of parts 20217-001 and 20221-001, which together apparently formed the subassembly. About the same time, Seagate Scotts Valley was considering a proposal to license Bull Peripheriques for the ST212 and ST225 disk drives.

4. Respondents Notices of Deficiency

Respondent determined in the notices of deficiency that the reasonable arm’s-length compensation for the component parts Seagate Singapore sold to Seagate Scotts Valley was the value added by Seagate Singapore in its assembly of the component parts (manufacturing overhead, labor, and general and administrative (G&A)) costs, facilities, etc., for 1983, 1984, and 1985; manufacturing overhead and labor for 1986 and 1987) plus a fee equal to 15 percent of the total value added, computed as follows:

Year Total value added 15-percent fee Reasonable arm’s-length compensation

1983 $2,106,000 $316,000 $2,422,000

1984 10,401,000 1,560,000 11,961,000

1985 6,481,000 972,000 7,453,000

1986 5,113,000 767,000 5,880,000

1987 3,902,000 585,000 4,487,000

5. Petitioner’s Experts *

a. Daniel P. Broadhurst

Mr. Broadhurst detailed Seagate Singapore’s component parts sales to Bull Peripheriques. Based on his review of Seagate Singapore’s books and records, Mr. Broadhurst calculated the following regarding component parts sales to Bull Peripheriques:

Invoice Invoice Sales Component date units amount Average standard price Cost

$14.60 20217-001 7/24/84 OO co o CO O O o CO

72.80 20221-001 7/24/84 bO © o TP Tt< Oi CO o 00

Total 960 41,952 87.40 50.30

Mr. Broadhurst noted in his report that fiscal year 1985 was the only year in which Seagate Singapore sold such component parts to Bull Peripheriques.

b. Gary E. Holdren

Mr. Holdren calculated weighted average sales prices of component parts sold by Seagate Singapore to Seagate Scotts Valley. He calculated average net sales prices for component parts 20217-001 and 20221-001 as follows:

[[Image here]]

c. Clark J. Chandler

Dr. Chandler evaluated whether respondent’s notice approach was appropriate and gave his opinion of what a rational procedure would be for determining a reasonable income for Seagate Singapore from the sale of component parts to Seagate Scotts Valley. Dr. Chandler concluded that respondent treated Seagate Singapore as a consignment manufacturer in calculating the section 482 reallocation for component parts and that respondent’s approach was not reasonable. He stated that from its inception Seagate Singapore operated as a turnkey supplier 5 of component parts and that respondent’s notice method fails to provide Seagate Singapore with an adequate return for the risks it incurred in taking title to materials and acting as a manufacturer of disk drive component parts.

Dr. Chandler stated that adequate data on arm’s-length comparables for the component parts produced by Seagate Singapore is not available because the component parts were used largely by Seagate Scotts Valley itself. He concluded further that the resale approach could not be used for similar reasons. Consequently, Dr. Chandler concluded that Seagate Singapore’s profits had to be evaluated largely in relation to its costs even though he believed that this approach would not be very precise in the instant case because profit margins varied widely within the industry both from year to year and among different companies.

Dr. Chandler concluded that material costs should not be excluded from the cost base because Seagate Singapore: (1) Took title to the materials it purchased from Seagate Scotts Valley; (2) purchased substantial amounts of materials directly from unrelated third parties; (3) incurred risks of material loss due to purchase price and scrap variances; and (4) was established in large part to provide Seagate Scotts Valley with effective access to low cost Far East sources of materials. Given the inclusion of materials in the cost base, he concluded that Seagate Singapore’s own profits on its sales of completed disk drives to unrelated third parties was perhaps the most obvious source for arm’s-length comparable transactions to. determine whether a section 482 reallocation was required for the sales of component parts to Seagate Scotts Valley. He acknowledged, however, that there is no guarantee that the margins for component parts and completed disk drives will be the same.

Using data on Seagate Singapore’s earnings from the sale of completed disk drives to unrelated third parties set forth in a report prepared by Erwin C. Chou, an Internal Revenue Service economist, Dr. Chandler estimated Seagate Singapore’s gross and operating profits for component parts sales. For Seagate Scotts Valley’s fiscal years ended 1984 through 1987, Dr. Chandler derived a cost-plus markup by dividing Seagate Singapore’s gross income (sales less cost of goods sold including returns and allowances) by its cost of goods sold. For Seagate Scotts Valley’s fiscal year ended 1983 he used Seagate Scotts Valley’s consolidated statement because there were no Seagate Singapore disk drive sales during that period. Then Dr. Chandler applied that markup to Seagate Singapore’s total cost of goods sold for component parts, excluding G&A costs, to derive a gross profit for component parts sales. Next, he deducted G&A costs from that gross profit to derive an operating profit on component parts sales.

Dr. Chandler concluded that, under his method, Seagate Singapore’s gross profit on sales of disk drives to unrelated parties was higher than the gross profit Seagate Singapore received on sales of component parts to Seagate Scotts Valley, and, therefore, no adjustment would be required with respect to the transfer price of component parts. Dr. Chandler acknowledged, however, that certain weaknesses exist in the use of Seagate Singapore’s gross profit on the sale of completed disk drives as an arm’s-length benchmark for component parts sales, such as the fact that: (1) The production of component parts requires a somewhat different technology; (2) the margins generated on Seagate Scotts Valley’s third party sales may be affected by product mix and, therefore, may not be representative of the margins realized by component parts producers; and (3) to the extent there are section 482 issues related to the valuation of intangibles, the assignment of purchasing costs, etc., such intercompany transactions may “taint” the margins developed from Seagate Singapore’s third party sales of completed disk drives.

As an alternative, Dr. Chandler used Seagate Scotts Valley’s overall operating income, divided by its consolidated cost of goods sold, as a measure of Seagate Singapore’s gross profit. Dr. Chandler used Seagate Scotts Valley’s operating income rather than its gross profit because Seagate Scotts Valley’s gross profit has to cover research and development (R&D) and marketing costs that Seagate Singapore did not incur with respect to component parts and because Seagate Scotts Valley’s consolidated G&A costs were substantially higher than Seagate Singapore’s G&A costs. Dr. Chandler conceded, however, that there are legitimate concerns in using Seagate Scotts Valley’s overall operating income as an appropriate arm’s-length benchmark because it is based in large part on sales of completed disk drives and affected by Seagate Scotts Valley’s profits from both its U.S. and Singapore operations. Nonetheless, he concluded that Seagate Scotts Valley’s results should serve as a proxy for using a successful Singapore firm as an arm’s-length benchmark because Seagate Scotts Valley’s consolidated operating income: (1) Is based on dealings with unrelated parties and, therefore, would be unaffected by section 482 issues; (2) is linked to Seagate Scotts Valley’s specific performance in the disk drive market and, therefore, places the same competitive pressures on Seagate Singapore’s component parts operations as they exist on Seagate Scotts Valley’s completed disk drive operations; and (3) averaged 13 percent of sales over the 1983-87 period and, therefore, falls within the range of profits for “high-tech electronics” reported in a study which provided some of the support for respondent’s adjustment, see infra Steven M. Zemsky.

Under his alternative method, Dr. Chandler divided Seagate Scotts Valley’s operating income by its cost of sales. The resulting markups ranged from a high of 26.4 percent in 1987 to a low of -6.3 percent in 1985. Then, he calculated Seagate Singapore’s gross profits by multiplying its cost of sales for component parts by the markup percentage for each year. Next, he calculated operating income by deducting G&A expenses from gross profits. Finally, he calculated the total estimated adjustment by subtracting Seagate Singapore’s operating income, as calculated above, from Seagate Singapore’s reported income. Adoption of Dr. Chandler’s alternate approach would lead to the following adjustment for each year:

Period ending Estimated adjustment

6/30/83 . $330,000

6/30/84 . 888,000

6/30/85 . 6,745,000

6/30/86 . 5,473,000

6/30/87 . (4,762,000)

Total 8,674,000

Dr. Chandler discusses the transaction with Bull Peripheriques in 1984 in one paragraph of his report. He states that the contract price, which was well above the controlled sales price for the same component parts, represents a price for component parts to an unrelated party which was to make the same use of the component parts as Seagate Scotts Valley. Dr. Chandler concluded that, although the actual volume of units shipped under the contract was small, the contract price for the component parts shipped was consistent with the established transfer price received by Seagate Singapore for component parts. Dr. Chandler does not state unequivocally, however, that the Bull Peripheriques transaction could serve as a comparable to the controlled sales of component parts.

In the course of preparing his report, Dr. Chandler traveled to Hong Kong and Singapore. There, he talked to a number of local PCB assemblers. Those PCB assemblers indicated that their markup on labor and overhead costs during the years in issue generally ranged between 10 and 20 percent; the markup on materials generally was somewhat lower.

6. Respondent’s Experts

a. Thomas Horst

Dr. Horst concluded that, as evidence of prices Seagate Scotts Valley paid unrelated third parties for component parts comparable to the component parts at issue was not available, the cost-plus method is the only practical method to estimate their arm’s-length prices. From his research, Dr. Horst concluded that Flextronics, Inc. (Flextronics), which provides turnkey contract manufacturing services to OEM’s, had operations which were the most similar to Seagate Singapore’s component parts manufacturing activities for the years in issue.

Flextronics manufactured and sold PCB’s to manufacturers of disk drives, computer printers, medical equipment, telecommunications equipment, and others. Sales to disk drive manufacturers accounted for 31.1 percent of Flextronics’ sales. Flextronics reported on a Securities and Exchange Commission (sec) Form S-l, Registration Statement Under the Securities Act of 1933, filed in August 1987 with the SEC that, historically, substantially all of its net income was derived from operations in Singapore and Hong Kong. It used the facilities located in those countries to provide turnkey manufacturing services to its Asian customers and high volume manufacturing capacity for its domestic customers. Flextronics further indicated on its Form S-l that the majority of its revenues was generated by its “turnkey” manufacturing services. Flextronics described its turnkey manufacturing as consisting of a package of services for the manufacture, in accordance with customer specifications, of PCB assemblies, subsystems, or complete electronic systems, including component procurement, assembly, and post-assembly testing.

Using information contained in the Form S-l, Dr. Horst divided Flextronics’ income from its operations in Asia (Flextronics-Asia) by the total sales of Flextronics-Asia for the fiscal years ended March 31, 1985, 1986, and 1987, to arrive at a weighted average operating profit margin for Flextronics-Asia of 10.8 percent. Using a formula, he then converted that percentage to a margin on total cost of 12.1 percent. Dr. Horst concluded that, operating at arm’s length, Seagate Singapore would have earned an operating profit margin equal to 12.1 percent of its total costs for its component parts manufacturing activities. He then applied that margin on total cost to Seagate Singapore’s “fully burdened cost” of component parts sales as calculated by Grant M. Clowery (see infra) to arrive at Dr. Horst’s estimate of a reasonable arm’s-length charge for the component parts.

Some of Flextronics-Asia’s sales relate to intercompany transactions.

b. Grant M. Clowery

Dr. Clowery provided detailed analyses of the profit and loss reported by Seagate Scotts Valley and Seagate Singapore and considered whether the results of the analyses reflect comparable accounting treatment of similar items. The results of Dr. Clowery’s analyses served as the basis against which benchmarks established for companies identified as comparables were compared by respondent’s expert economists, Dr. Horst (see supra) and Daniel J. Frisch (see infra).

Dr. Clowery reviewed individual income statements of Seagate Scotts Valley and Seagate Singapore for their fiscal years 1984 through 1987 to calculate the elements of the various accounts; for example, sales, cost of goods sold (cost of sales), selling, and G&A. He first developed a side-by-side comparison of Seagate Scotts Valley’s consolidated income statements. Then, Dr. Clowery made certain adjustments to some of those elements that he concluded consistent accounting treatment required him to make to calculate gross profit and operating profit for Seagate Scotts Valley and Seagate Singapore in the same manner. After he developed comparable income statements based on transactions as recorded by Seagate Scotts Valley, Dr. Clowery considered additional adjustments that could be made to reflect alternative arrangements.

For the sales of component parts, Dr. Clowery calculated adjustments to the cost of goods sold to compute a “fully burdened” cost of goods sold against which Dr. Horst applied his estimated arm’s-length markup. In calculating the “fully burdened” cost of goods sold, Dr. Clowery first used Seagate Scotts Valley’s product line income statements based on monthly reports of operating results furnished by Seagate Scotts Valley to determine the percentage of Seagate Singapore sales of component parts to total Seagate Singapore sales. Seagate Singapore separately reported intercompany sales and sales to third parties. At respondent’s request, Dr. Clowery further allocated the third parties’ sales to the destinations to which the goods were shipped (i.e., local distributors, U.S. destinations, and foreign destinations).

Next, he obtained cost of goods sold data from the product line income statements and, in the case of third party sales, he further allocated the sales to the three destinations described above based on the percentage of sales to each. Dr. Clowery then multiplied Seagate Singapore’s total allocated selling and general and administrative (SG&A) expenses by the appropriate percentage to determine the amount of SG&A expenses attributable to Seagate Singapore’s component parts sales to Seagate Scotts Valley. Finally, he added that result to Seagate Singapore’s cost of goods sold, including materials, to arrive at the “fully burdened” cost of goods sold.

Seagate Singapore’s net component parts sales, cost of goods sold (COGS), and gross profit (GP) as reported on Seagate Scotts Valley’s income statements for the years in issue, as calculated by Dr. Clowery, are as follows:

[[Image here]]

Seagate Singapore’s net component parts sales, “fully burdened” cost of goods sold (FBCOGS), and gross profit after adjustments made by Dr. Clowery for the years in issue are as follows:

[[Image here]]

Dr. Clowery then multiplied his derived “fully burdened” cost of goods sold by the 12.1-percent markup determined by Dr. Horst to obtain the estimated arm’s-length gross profit for Seagate Singapore for the years in issue. To derive the increase (decrease) in Seagate Singapore’s net income resulting from the proposed revisions in Seagate Singapore’s gross profit from component parts sales, Dr. Clowery subtracted the gross profit he calculated based on a 12.1-percent markup from the gross profit he calculated based on a “fully burdened” cost of goods sold, as follows:

[[Image here]]

c. Steven M. Zemsky

During May and June 1984 Mr. Zemsky traveled to Singapore, Malaysia, Hong Kong, Taiwan, and South Korea. During that trip he and others visited and interviewed a number of local Asian assemblers involved in the electronics industry, including PCB assemblers. Based on his interviews, Mr. Zemsky concluded that from 1982 through at least the summer of 1984 the Asian subcontractors involved in PCB assembly work earned 4- to 6-percent net profit on sales. Mr. Zemsky further concluded that, on average, firms supplying only assembly services on a consignment basis marked up their labor costs by 10 percent. In semiconductors and other high-tech products industries (e.g., monitors, printers, keyboards, PCB’s (manufacturing or multi-layered), telephones), however, net profits tended to range between 10 and 20 percent of sales.

7. Other Third Party Transactions

During April 1986, Seagate Scotts Valley entered into a spare parts purchasing agreement with an OEM customer. Pursuant to that agreement, Seagate Scotts Valley agreed to sell to the OEM customer described parts, assemblies, and subassemblies, including PCB’s, for various disk drive models sold by Seagate Scotts Valley. Seagate Scotts Valley gave the OEM customer a 40-percent discount from the list prices of the described spare parts. Additionally, the agreement provided that if the OEM customer canceled any purchase orders issued pursuant to the agreement, for spare parts to be delivered within 60 days of the effective date of the cancellation, the OEM customer would pay Seagate Scotts Valley for the reasonable and direct material and labor costs incurred for such parts, plus a reasonable profit not to exceed 10 percent on such material and labor costs.

Seagate Scotts Valley offered other customers discounts on purchases of spare parts, generally based on the value per purchase order, in amounts ranging up to 40 percent.

B. OPINION

1. Ultimate Findings of Fact

In the notices of deficiency, respondent did not follow the cost-plus method described in section 1.482-2(e)(4), Income Tax Regs. Under the method respondent used to determine the reallocations relating to the sale of the component parts in issue, respondent treated Seagate Singapore as a consignment manufacturer and allowed a markup on costs based on the lower risks faced by consignment manufacturers. Respondent also did not include Seagate Singapore’s materials costs in the costs to which the markup was added.

Seagate Singapore is not merely a consignment manufacturer of component parts. Seagate Singapore is entitled to be compensated for the increased risks and responsibilities it assumed during the years in issue. Respondent’s reallocations for the component parts pricing issue are arbitrary and excessive.

2. The Methods

The regulations under section 482 provide that when one controlled entity sells tangible property to another controlled entity at other than an arm’s-length price, respondent is authorized to make appropriate reallocations between the seller and the buyer to reflect an arm’s-length price for the sale. An arm’s-length price is the price an unrelated party would have paid under the same circumstances for the same property involved in the controlled sale. An arm’s-length price normally involves a profit to the seller. Sec. 1.482-2(e)(l)(i), Income Tax Regs.

The regulations specify three methods, in order of priority, which must be used to determine an arm’s-length price for the sale of tangible property: The comparable-uncontrolled-price method (cup); the resale-price method; and the cost-plus method. Sec. 1.482 — 2(e)(l)(ii), Income Tax Regs. Where none of these three methods can reasonably be applied under the facts and circumstances of a particular case, the regulations authorize use of any other appropriate method, or variations of such methods, for determining an arm’s-length price. Sec. 1.482 — 2(e)(l)(iii), Income Tax Regs.

Neither party has proposed that the resale price method should apply to the sale of the component parts under the circumstances of the instant case. We agree that the record does not support application of that method. Consequently, we will not discuss it.

Both parties have presented expert testimony in support of their positions. We weigh expert testimony in light of the expert’s qualifications as well as all the other credible evidence in the record. Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990). We are not bound by the opinion of any expert witness, and we will accept or reject that expert testimony when, in our best judgment, based on the record, it is appropriate to do so. Id.; Chiu v. Commissioner, 84 T.C. 722, 734 (1985). While we may choose to accept the opinion of one expert in its entirety, Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we may also be selective in the use of any portion of that opinion, Parker v. Commissioner, 86 T.C. 547, 562 (1986).

a. The Comparable Uncontrolled Price (CUP) Method

i. The CUP Method in General

Under the CUP method, the arm’s-length price of a controlled sale is equal to the price paid in comparable uncontrolled sales. Sec. 1.482-2(e)(2)(i), Income Tax Regs. Uncontrolled sales for purposes of the CUP method include: (1) Sales made by the taxpayer to an unrelated party; (2) purchases made by the taxpayer from unrelated parties; and (3) sales made between two unrelated parties. Sec. 1.482-2(e)(2)(h), Income Tax Regs. Controlled and uncontrolled sales are deemed comparable if the physical property and circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales, or if such properties and circumstances are so nearly identical that any differences either have no effect on price, or can be measured and eliminated by making a reasonable number of adjustments to the price of the uncontrolled sales. Some of the differences which may affect the price of property are differences in quality of the product, terms of sale, intangible property associated with the sale, time of sale, the level of the market, and the geographic market in which the sale takes place. Sec. 1.482-2(e)(2)(ii), Income Tax Regs; see also Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 585-586 (1989), affd. 933 F.2d 1084 (2d Cir. 1991).

ii. The Parties’ Positions on the CUP Method and the Court’s Holding as to Its Application

Petitioner contends that Seagate Singapore charged Seagate Scotts Valley arm’s-length prices for the component parts. Petitioner contends that the transaction with Bull Peripheriques supports its position that the intercompany transfer prices were arm’s length. Petitioner contends that the prices for the two component parts sold to Bull Peripheriques during 1984 were arms’s length and, under the CUP method, should be used to determine the transfer price for its intercompany sales of compbnent parts.

Dr. Horst criticizes the use of the 1984 Bull Peripheriques transaction as a comparable to Seagate Singapore’s sales of component parts to Seagate Scotts Valley. He agrees that the property sold to Bull Peripheriques meets the physical identity of property requirement of section 1.482-2(e)(2), Income Tax Regs., but he finds reliance on that transaction unconvincing in light of the insignificant volume of sales involved in the Bull Peripheriques transaction 6 and the uncertainty as to whether the other economic circumstances relating to those sales were similar or sufficiently similar to the sales of component parts to Seagate Scotts Valley.

Dr. Horst’s criticism of the Bull Peripheriques transaction as a reliable comparison is bolstered by Dr. Chandler’s conclusion that adequate data on arm’s-length comparables for Seagate Singapore’s component parts sales is not available. Dr. Chandler only makes an oblique reference in one paragraph of his lengthy report to the Bull Peripheriques transaction.

For controlled sales of many different products or many separate sales of the same product, the regulations under section 482 recognize that it may be impractical to ascertain an arm’s-length price for each product or sale. In such circumstances, the regulations permit the application of the appropriate pricing method to product lines or other groupings. Sec. 1.482-2(e)(l), Income Tax Regs.' In the instant case, however, petitioner presented no evidence to establish that the sales prices for the component parts involved in the Bull Peripheriques transaction were representative of the sales prices of all of the component parts sold during the years in issue.

Moreover, petitioner did not establish that the circumstances involved in the transaction with Bull Peripheriques, representing a minuscule portion of the total third party sales of component parts, were sufficiently similar to the circumstances involved in the controlled sales of component parts. We find it noteworthy that petitioner failed to point to any specific uncontrolled sales of component parts other than one sale of 480 subassemblies to a company which Seagate Scotts Valley was considering as a licensee. Sec. 1.482-2(e)(2)(ii), Income Tax Regs. Consequently, we conclude that the Bull Peripheriques transaction is not a comparable transaction to the uncontrolled sales of component parts.

b. The Cost-Plus Method

i. The Cost-Plus Method in General

Under the cost-plus method, an arm’s-length price is determined by adding to the seller’s cost of producing the property involved in the controlled sale the gross profit percentage (expressed as a percentage of cost) earned on the uncontrolled sale or sales of property most similar to the controlled sales in question. Sec. 1.482-2(e)(4)(i), (iii), Income Tax Regs. The cost of producing the property involved in the controlled sale, and the costs which enter into the computation of the gross profit percentage, must be computed in a consistent manner in accordance with sound accounting practices for allocating or apportioning costs, which neither favors nor burdens controlled sales in comparison with uncontrolled sales. Sec. 1.482 — 2(e)(4)(ii), Income Tax Regs.

If possible, gross profit percentages should be derived from uncontrolled sales made by the seller involved in the controlled sales because similar characteristics are more likely to be found among sales by the same seller than among sales made by other sellers. Sec. 1.482-2(e)(4)(iv), Income Tax Regs. In the event that the most similar sale or sales from which the appropriate gross profit percentage is derived differ in any material respect from the controlled sales (i.e., differences which have a definite and reasonably ascertainable effect on price), the arm’s-length price must be adjusted to reflect the differences to the extent the differences would warrant an adjustment of price in uncontrolled transactions. Sec. 1.482 — 2(e)(4)(v), Income Tax Regs.

Section 1.482 — 2(e)(4)(iii), Income Tax Regs., designates the following characteristics as the most important in analyzing the similarity of the uncontrolled sale or sales:

(a) The type of property involved in the sales. For example: machine tools, men’s furnishings, small household appliances.

(b) The functions performed by the seller with respect to the property sold. For example: contract manufacturing, product assembly, selling activity, processing, servicing, delivering.

(c) The effect of any intangible property used by the seller in connection with the property sold. For example: patents, trademarks, trade names.

(d) The geographic market in which the functions are performed by the seller.

In general, the similarity to be sought relates to the probable effect upon the margin of gross profit of any differences in such characteristics between the uncontrolled sales and the controlled sale. Thus, close physical similarity of the property involved in the sales compared is not required under the cost plus method since a lack of close physical similarity is not necessarily indicative of dissimilar profit margins. * * *

ii. The Parties’ Positions on the Cost-Plus Method as Applied by Dr. Horst and the Court’s Ruling as to That Méthod

Respondent argues that a reasonable arm’s-length compensation for the component parts Seagate Singapore sold to Seagate Scotts Valley is the 12.1-percent markup on materials, labor, and overhead applied by Dr. Horst to Seagate Singapore’s “fully burdened” cost of goods sold as derived by Dr. Clowery. Respondent contends that 12.1 percent is a reasonable markup because of the limited risks faced by Seagate Singapore and the low technological processes involved in manufacturing and assembling the component parts. Respondent finds further support for Dr. Horst’s recommended markup because Seagate Singapore’s PCB subcontractors charged Seagate Singapore an 8- to 10-percent cost-plus margin for the same types of pcb’s that Seagate Singapore was assembling; Asian PCB subcontractors generally marked up their labor and overhead costs between 10 and 20 percent and materials somewhat less; Asian PCB assemblers during a portion of the years in issue generally earned between 4- and 6-percent net profit on sales; and the cancellation clause in the April 1986 spare parts purchasing agreement between Seagate Scotts Valley and a certain OEM customer provided that the OEM customer would pay Seagate Scotts Valley a cancellation fee which included a reasonable profit, not to exceed 10 percent.

Petitioner contends that the gross profit percentage advanced by respondent would compensate Seagate Singapore only on the basis of a contract manufacturer. Petitioner argues that such percentage is inadequate to compensate Seagate Singapore for all the risks and responsibilities it incurred in manufacturing and assembling the component parts. Petitioner contends further that Dr. Horst’s analysis contains significant factual and methodological flaws and that his conclusions regarding Seagate Singapore’s transfer prices for component parts are therefore without merit. Additionally, petitioner contends that Flextronics-Asia’s financial data, when properly analyzed, actually supports the arm’s-length nature of Seagate Singapore’s charges to Seagate Scotts Valley for component parts.

Petitioner contends that Dr. Horst failed to consider anything but minimal information concerning Flextronics. As a result, petitioner argues, Dr. Horst did not know about significant aspects of Flextronics’ activities which relate directly to his analysis, such as whether Flextronics’ costs and profit margins associated with its manufacture of pcb’s for disk drive manufacturers were the same as the costs and profit margins associated with its manufacture of pcb’s for other industry segments, or which industry segment’s pcb’s were manufactured in Asia and which were manufactured in the United States. Petitioner contends it was therefore impossible for Dr. Horst to determine whether the margins earned by Flextronics-Asia are comparable to those earned by Seagate Singapore.

Petitioner argues that Dr. Horst’s calculations for Flextronics-Asia include both controlled and uncontrolled sales and, as a result, Dr. Horst’s methodology does not comply with section 1.482-2(e)(4), Income Tax Regs., which requires that the comparable gross profit percentage be computed on the basis of uncontrolled sales.

Additionally, petitioner contends that Dr. Horst’s method is an operating profit markup based on fully loaded costs (i.e., net sales, less cost of sales, less SG&A expenses) that does not comply with the cost-plus method described in section 1.482-2(e)(4), Income Tax Regs., which is based on a gross profit markup on cost of sales. According to petitioner, Dr. Horst’s method both radically distorts the appropriate markup percentage and is mathematically flawed.

Finally, petitioner argues that if the cost-plus method described in section 1.482-2(e)(4), Income Tax Regs., is applied to the financial data relating only to Flextronics-Asia’s uncontrolled sales, the result would support the arm’s-length nature of Seagate Singapore’s transfer prices. According to petitioner, if Flextronics-Asia’s overall gross margin for 1985, 1986, and 1987 is calculated using Dr. Clowery’s methodology of allocating SG&A expenses, based on the financial data reflected on Flextronics’ SEC filings, Flextronics-Asia’s gross margin would be 18.8 percent. Petitioner then posits that, if Dr. Horst’s conversion formula is used, Flextronics-Asia’s markup on total cost would be 23.2 percent. Petitioner contends that comparing those results to Seagate Singapore’s overall gross margin on component parts sales during such period (which petitioner calculates to be 17.48 percent) and Seagate Singapore’s markup on costs (calculated to be 21.18 percent) shows that Seagate Singapore earned lower margins and marked up its costs less on its sales of component parts to Seagate Scotts Valley than Flextronics did on its sales to third parties.

We agree that Dr. Horst does not apply the cost-plus method described in section 1.482-2(e)(4), Income Tax Regs. Because we conclude that Dr. Horst’s methodology is flawed, we also must reject as unreasonable his recommended transfer prices for the component parts.

Under section 1.482-2(e)(4), Income Tax Regs., the appropriate gross profit percentage (expressed as a percentage of the cost of producing the property involved in the uncontrolled sale) is computed for the seller or another party on an uncontrolled sale of property which is most similar to the controlled sale in question. The cost of producing the property involved in the controlled sale is then multiplied by the appropriate gross profit percentage to ascertain the markup to the cost of producing that property which the controlled seller would have earned had the controlled sale been at arm’s length. The cost of producing the property involved in the controlled sale plus that markup is the arm’s-length price of the property involved in the controlled sale. Sec. 1.482— 2(e)(4), Income Tax Regs.

The Form S-l for Flextronics, which Dr. Horst used to compute his approximated gross profit percentage, provided operating income information, but not gross profit data, by geographic segments. Dr. Horst, therefore, used the operating income data for Flextronics’ Asian operations to compute an operating income percentage for Flextronics-Asia. He then converted the operating income percentage to a gross profit percentage through the use of a mathematical formula. Dr. Horst’s methodology, therefore, clearly does not meet the description of the cost-plus method set forth in section 1.482-2(e)(4), Income Tax Regs., but is a variation of the cost-plus method. Under the regulations, a variation of one of the three specified transfer pricing methods is a fourth method which can be applied, if appropriate, when none of the three specified methods reasonably can be applied under the facts and circumstances. Sec. 1.482 — 2(e)(l)(iii), Income Tax Regs. The record in the instant case, however, does not support the method applied by Dr. Horst.

Based on the SEC filings for Flextronics in the record, we agree that Flextronics-Asia’s uncontrolled sales of pcb’s and other computer peripheral equipment appear sufficiently similar to the controlled sales of component parts by Seagate Singapore. Unfortunately, the financial information available for Flextronics-Asia is not sufficient to derive the appropriate gross profit percentage of Flextronics-Asia’s uncontrolled sales. The available data does not include gross profit information for uncontrolled sales. We do not agree with petitioner that such information can be ascertained by applying Dr. Clowery’s allocation formula because we do not find that there is a reasonable basis in the record to conclude what percentage of SG&A expenses relate solely to Flextronics-Asia’s operations. Moreover, it is not clear from Flextronics’ Form S-l whether the operating income reported on that form includes income from its controlled sales as well as its uncontrolled sales. In determining the appropriate gross profit percentage, only sales of property from similar, uncontrolled sales may be considered. Sec. 1.482-2(e)(4)(iv), Income Tax Regs. Consequently, we are unable to determine an appropriate gross profit percentage from the available information. As a result, we must reject as unreasonable the transfer prices for component parts proposed by Dr. Horst.

iii. The Parties’ Positions on Applying the Cost-Plus Method Using the Bull Peripheriques Sale and the Court’s Holding as to That Method

Petitioner contends that the sale to Bull Peripheriques of 480 subassemblies provides a basis for concluding that the intercompany sales of component parts were at arm’s length under the cost-plus method. According to petitioner, based on Mr. Broadhurst’s report, the sale to Bull Peripheriques establishes that Seagate Singapore earned gross profit percentages of 43 percent and 42 percent on sales of component parts to unrelated parties. Petitioner contends that Seagate Singapore earned gross profit percentages of only between 9.5 percent and 28.4 percent on intercompany sales of component parts and no adjustment to the transfer prices for component parts is therefore required.

Respondent counters that the gross profit percentage Seagate Singapore earned on the Peripheriques sale cannot be computed on the basis of the information contained in Mr. Broadhurst’s report. Respondent contends that petitioner has not established Seagate Singapore’s actual cost of producing the component parts and that, therefore, no basis exists in the record for determining an appropriate gross profit percentage. We agree.

The record does not establish Seagate Singapore’s actual gross profit percentages earned during the years in issue separately from the sales of component parts to unrelated third parties and to Seagate Scotts Valley. To compute the gross profit percentage Seagate Singapore earned on the sale to Bull Peripheriques, petitioner subtracted Seagate Singapore’s standard costs for the parts from the average sales price and divided the result by the average sales price. Petitioner did not establish that the standard cost for the parts approximated the actual cost of producing the parts. Moreover, petitioner did not establish that the gross profit percentage it calculated for the Bull Peripheriques sale is representative of the gross profit percentages Seagate Singapore earned on its other third party component parts sales. Consequently, we conclude that petitioner has not shown through the 1984 Bull Peripheriques transaction that the transfer prices for Seagate Singapore’s controlled sales to Seagate Scotts Valley were at arm’s length.

iv. The Parties’ Position on Applying the Cost-Plus Method Using Dr. Chandler’s Approaches and the Court’s Holding as to That Method

Additionally, petitioner contends that Br. Chandler’s methodology of using the cost-plus markup on Seagate Scotts Valley’s third party disk drive sales as the cost-plus markup on Seagate Singapore’s component parts sales to Seagate Scotts Valley establishes that no adjustment is required with respect to the transfer price of the component parts. For the reasons Dr. Chandler cites in his own report, we reject Dr. Chandler’s methodology.

Petitioner has presented no evidence to establish that Seagate Scotts Valley’s markup on disk drive sales approximates an arm’s-length markup for component part sales. We are convinced, moreover, that, because of their complexity, the risks involved in the sale of disk drives is much greater than the risks involved in the sale of the component parts in issue. Consequently, we would expect that a manufacturer operating at arm’s length could expect to earn a greater return on the sale of disk drives than on the sale of component parts. Consequently, we conclude that petitioner has not shown that Seagate Scotts Valley’s markup on disk drive sales is an appropriate markup for Seagate Singapore’s component part sales.

Dr. Chandler also proposed an alternate approach, using Seagate Scott Valley’s overall operating income divided by Seagate Scotts Valley’s consolidated cost of goods sold to determine Seagate Singapore’s gross profit. On brief, petitioner does not urge the adoption of that alternate approach.

Dr. Chandler’s alternate approach does not apply the cost-plus method described in section 1.482 — 2(e)(4), Income Tax Regs. For the reasons Dr. Chandler cites in his own report, we find Dr. Chandler’s alternative approach also unreliable for the purpose of deciding the transfer prices for the component parts.

Consequently, petitioner has failed to establish through its proposed cost-plus methodologies that the transfer prices for the component parts were arm’s-length charges.

c. The Court’s Holding as to the Arm’s-Length Transfer Price for Component Parts Sold to Seagate Scotts Valley

We have considered the other arguments raised by the parties and find them unpersuasive. As discussed supra, we have concluded that petitioner and respondent have failed to establish reasonable transfer prices for the component parts Seagate Singapore sold to Seagate Scotts Valley under the CUP or cost-plus methodologies advanced by their experts. We further conclude that the record does not contain sufficient information from which we can derive a reasonable transfer price under the CUP, resale price, or cost-plus methods as described in. section 1.482 — 2(e)(2), (3), and (4), Income Tax Regs.

We agree with both Dr. Chandler and Dr. Horst that under the circumstances of the instant case the cost-plus method is the most appropriate method to establish a reasonable transfer price for the component parts in issue. Unfortunately, the record does not provide sufficient evidence to establish an appropriate gross profit percentage under the method described in section 1.482-2(e)(4), Income Tax Regs. Consequently, we make our best estimate of the appropriate transfer prices for the component parts on the basis of the available record. Sundstrand Corp. v. Commissioner, 96 T.C. 226, 375 (1991).

We think that Seagate Singapore was more than a consignment contractor and, thus, it should be compensated for its greater risks and responsibilities. The record establishes that many Asian subcontractors marked up their labor and overhead costs between 10 and 20 percent, while they marked up their materials costs somewhat less. Furthermore, local PCB assemblers to whom Seagate Singapore subcontracted some of its PCB assembly work marked up their labor and overhead costs between 8 and 10 percent. We believe that, because of the greater responsibilities and risks undertaken by Seagate Singapore in the manufacture and assembly of the component parts, if Seagate Singapore had been operating at arm’s length, it would have sought a markup at the high end of the range earned by Asian subcontractors.

Petitioner argues that the prices Seagate Singapore charges Seagate Scotts Valley for component parts (that is, the standard cost of manufacturing the component part in Singapore, plus 25 percent of those costs) are arm’s length. On the other hand, respondent argues that Seagate Singapore’s “fully burdened” cost of goods sold for the component parts, plus a 12.1-percent markup on materials, labor, and overhead, are the arm’s-length prices for the component parts. For the reasons discussed infra (Issue 4), we reject Dr. Clowery’s calculation of Seagate Singapore’s “fully burdened” cost of goods sold for the component parts. Respondent does not otherwise challenge Seagate Singapore’s costs of materials, labor, and overhead for the component parts. As stated above, we believe that Seagate Singapore, due to the greater risks it undertook, would have sought a markup at the high end of the range earned by Asian subcontractors. Consequently, we hold that the reasonable transfer price for the component parts is Seagate Singapore’s materials, labor, and overhead costs, plus 20 percent. We apply the 20-percent rate to the cost of materials, as well as the costs of labor and overhead, to provide for the greater risks undertaken by Seagate Singapore than the risks undertaken by Asian subcontractors.

V. ISSUE 4

Whether Seagate Scotts Valley paid Seagate Singapore an arm’s-length price for completed disk drives Seagate Singapore produced and sold to Seagate Scotts Valley.

A. FINDINGS OF FACT

1. Disk Drive Manufacturing and Sales

In the disk drive industry, Seagate Scotts Valley was not considered to be a technology leader. Rather than relying on proprietary, leading edge technology, Seagate Scotts Valley’s corporate strategy was to expand the disk drive market as much as possible and then to compete in that market by manufacturing and selling the least expensive, best quality, and most reliable disk drives available. Seagate Scotts Valley assisted in market expansion by offering information regarding manufacturing standards to all other manufacturers. Seagate Scotts Valley felt that to succeed, it needed to market a high quality product which it could sell at a low price.

During 1983, Seagate Scotts Valley’s management decided that Seagate Singapore should manufacture completed disk drives as well as component parts. Seagate Singapore began selling completed disk drives to Seagate Scotts Valley during the fiscal year ended June 30, 1984. Volume production of disk drives began at Seagate Singapore during the second half of that fiscal year. Seagate Scotts Valley was Seagate Singapore’s largest disk drive customer overall. The rapid growth in the manufacture of disk drives by Seagate Singapore required the expansion of Seagate Singapore’s employee force in Singapore.

Fierce competition in the low-end disk drive market eroded Seagate Scotts Valley’s market share for disk drives, causing manufacturers, distributors, and value-added resellers (var’s) to compete for the same customers. Prices for disk drives generally declined very rapidly. Seagate Scotts Valley’s prices for disk drives could vary as to the customer involved or the volume of disk drives ordered. Some of the OEM’s demanded that the prices charged to them be the same as or lower than the prices Seagate Scotts Valley charged to other similarly situated customers for similar or lesser quantities of products of like quality. In at least one instance, for a time, the structure of Seagate Scotts Valley’s prices for the ST4051 disk drive models it sold to a division of a large OEM customer reimbursed the OEM customer for its collaboration in the development of that disk drive model.

Some of Seagate Scotts Valley’s customers placed severe pricing pressures on Seagate Scotts Valley. For example, during June 1984, IBM demanded an immediate decrease in its purchase price for the ST412 disk drive.

Seagate Singapore generally sold the same disk drive models to third parties and Seagate Scotts Valley. Seagate Singapore’s sales of disk drives to Seagate Scotts Valley and to third parties customarily were f.o.b. Seagate Singapore. When Seagate Singapore sold disk drives to Seagate Scotts Valley, Seagate Scotts Valley usually was responsible for freight, insurance, and duty charges. When Seagate Singapore sold disk drives to a third party, the third party also generally was responsible for freight, insurance, and duty charges.

During April 1985, Seagate Scotts Valley entered into an industrial distributorship agreement with Co. T, 7 West Germany, giving Co. T the nonexclusive right to purchase as an industrial OEM distributor the ST506, ST412, ST212, ST225, ST125, ST4026, ST4038, and ST4051 disk drive models, and additional products as later added, for resale, lease, or other disposition, within West Germany. The agreement provided, among other things, for Seagate Scotts Valley to repurchase, within limits, obsolete products or parts at their original price, less any credits, and to replace upgraded products. The agreement gave Co. T the right to establish its resale prices for the products it purchased from Seagate Scotts Valley. Shipments were f.o.b. factory and payments were due net 60 days from date of invoice. The agreement provided for Seagate Scotts Valley to cofund, with prior approval, Co. T’s advertising, promotion, and trade show expenses relating to Seagate Scotts Valley’s products.

During October 1986, Seagate Scotts Valley entered into an international distributor agreement with Co. U, West Germany, giving Co. U the nonexclusive right to distribute all of Seagate Scotts Valley’s products within West Germany and West Berlin. The distributor agreement Seagate Scotts Valley entered into with Co. U is substantially the same as, but not identical to, the distributor agreement with Co. T.

During March 1987, Seagate Scotts Valley entered into an international distributor agreement with Co. V, West Germany, giving Co. V the nonexclusive right to distribute the ST225 and ST4038 disk drive models, and additional products as later added, in West Germany and West Berlin. The agreement is substantially the same as, although not identical to, the agreements with Co. T and Co. U. Prices, however, for Seagate Scotts Valley’s products were quoted f.o.b. Amsterdam, duty unpaid. Additionally, the agreement with Co. V was amended during 1987 to provide, in the event of a price decrease, a credit, within limits, of the difference between the old and new prices for Seagate Scotts Valley’s products still in Co. V’s inventory.

During June 1984, Seagate Scotts Valley entered into an industrial distributorship agreement with Co. W, California, and some of its divisions, giving Co. W the nonexclusive right to purchase as an industrial OEM distributor the ST212, ST412, ST419, and ST425 disk drive models, and additional products as later added, for resale, lease, or other disposition, to others in the United States and Puerto Rico. Co. X, a division of Co. W, is a large distributor of computer peripheral equipment and other electronics^ Co. X resold Seagate Scotts Valley’s disk drives to small OEM’s, systems integrators, and retailers. The agreement with Co. W provided, among other things, for Seagate Scotts Valley to repurchase, under certain conditions, at Co. W’s option, excess inventory and gave Co. W credit against purchases of new products for slow moving inventory returned to Seagate Scotts Valley by Co. W. The agreement gave Co. W a discount for early payment of its account. The agreement authorized Co. W to use Seagate Scotts Valley’s trademarks, trade names, and logos in connection with the sale of Seagate Scotts Valley’s products. The agreement quoted prices at decreasing levels, inversely to increasing quantities of products ordered. The lowest price was quoted for quantities ranging from 1000 to 2500 units. A 20-percent distributor gross margin was projected for prices quoted for the highest volume ordered. Other provisions of the distributor agreement with Co. W are similar to the distributor agreements with Co. T, Co. U, and Co. V. Sometime later, Co. W terminated the distributorship relationship with Seagate Scotts Valley, apparently because Co. X could not obtain its desired gross margin percentage from the resale of Seagate Scotts Valley’s products. The record does not establish the actual gross profit percentages that Co. X earned on the resale of disk drives or similar products.

Seagate Scotts Valley also entered into other distributorship agreements with other domestic and international companies which are similar, although not identical, to the distributor agreements with Co. T, Co. U, Co. V, and Co. W. Some of the distributor agreements with the international companies quote prices f.o.b. Amsterdam. Seagate Scotts Valley opened a stocking and distribution facility in Amsterdam sometime during the years in issue.

During some of the years in issue, Co. A purchased and resold Seagate Scotts Valley’s disk drives to OEM’s and dealers, including independent dealers, regional distributors, VAR’s, and large retail outlets located throughout the world. Seagate Scotts Valley’s disk drives made up a significant portion of Co. A’s inventory purchases for 1987. In addition to Seagate Scotts Valley’s disk drives, Co. A sold other hard disk drives, hard disk drive subsystems, accessories, and peripherals. At some point, Co. A changed its business from retailer to high-volume distributor of its own products. To gain entry and market share in the highly competitive environment into which it had embarked, Co. A sold its own products during some of the years in issue at a lower gross margin than customary. The consolidated financial statements of Co. A’s Form 10-K, annual report filed under section 13 or 15(d) of the Securities Exchange Act of 1934, for the fiscal year ended June 30, 1987, include the accounts of Co. A Pte. Ltd. (Singapore), a wholly owned offshore assembly facility located in Singapore. The Form 10-K indicates Co. A’s gross profit percentages, as a percentage of sales, for 1985, 1986, and 1987, were 8.8 percent, 10.9 percent, and 9.5 percent, respectively.

As a general matter, at least for years after 1986, Seagate Scotts Valley informed its new distributors that they should plan on experiencing gross margins of 10 percent or below.

Effective July 1, 1986, Seagate Scotts Valley entered into a sales representative agreement with an independent contractor (the representative) engaged in the business of soliciting orders from customers for the sale of certain products, giving the representative the nonexclusive right to solicit orders in specified States and parts of Canada for all of Seagate Scotts Valley’s products. The agreement provided for Seagate Scotts Valley to compensate the representative for OEM customer orders on a commission basis, ranging as follows:

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For services the representative rendered with respect to Seagate Scotts Valley’s authorized distributors, the agreement provided for Seagate Scotts Valley to compensate the representative on the basis of a commission of 5 percent of the net sales of the products made by those distributors for delivery within the representative’s territory.

Seagate Scotts Valley resold the disk drives it purchased from Seagate Singapore to third parties. Seagate Scotts Valley warranted the products it sold for periods of 12 to 18 months regardless of the place they were manufactured.

Seagate Scotts Valley paid for all advertising. Seagate Singapore provided some subsidy to its Asian distributors to assist them in advertising Seagate Scotts Valley’s products.

At times, Seagate Scotts Valley’s distributors in Europe and Asia encountered competition from resellers who purchased disk drives from Seagate Scotts Valley and then resold them abroad, sometimes at prices lower than the prices Seagate Scotts Valley’s distributors charged for the same disk drives.

Distributors in Asia generally took much smaller order quantities than U.S. distributors.

The personal computer market in Europe during the mid-1980s was less developed and less mature than such market in the United States at that time.

2. Respondent’s Notices of Deficiency

In the notices of deficiency, respondent determined that a reasonable transfer price for the disk drives Seagate Singapore sold to Seagate Scotts Valley was a discount of 20 percent of the resale price of the disk drive sales marketed and contracted by Seagate Scotts Valley. Additionally, to account for any nominal marketing activities by Seagate Singapore and any costs incurred by Seagate Singapore in making disk drive sales, respondent, in effect, allowed Seagate Scotts Valley an offset equal to 1 percent of Seagate Singapore’s direct disk drive sales.

At the time respondent’s agents computed the transfer price reallocation for the disk drives in issue, the agents concluded that they did not have sufficient information to determine the resale price Seagate Scotts Valley received from unrelated third parties for the disk drives produced by Seagate Singapore. In order to determine the reasonable value of Seagate Scotts Valley’s services in marketing the subject disk drives, therefore, Dr. Chou, the Internal Revenue Service economist assigned to the audit of Seagate Scotts Valley’s tax returns, used Seagate Singapore’s sales revenue for disk drives, adjusted as explained infra, in an attempt to approximate Seagate Scott Valley’s actual resale price.

In calculating the reasonable value of Seagate Scotts Valley’s marketing services, Dr. Chou first increased (reduced for 1985) the sales revenue Seagate Singapore received on intercompany sales of disk drives by a “price allowance”. 8 The sales revenue Seagate Singapore earned from intercompany transactions, Dr. Chou’s price allowances, and the derived adjusted intercompany sales revenue from disk drive sales, as reflected in the notices of deficiency, are as follows:

Year Intercompany disk drive sales Price adjustment Adjusted intercompany disk drive sales

1984 $19,700,000 $6,161,000 $25,861,000

1985 61,786,000 (2,401,000) 59,385,000

1986 216,707,000 16,862,000 233,569,000

1987 433,340,000 86,804,000 520,144,000

Dr. Chou then added the adjusted intercompany disk drive sales revenue to the revenue from third party sales to calculate Seagate Singapore’s “adjusted sales” for the applicable year.

Next, Dr. Chou multiplied the “adjusted sales” for the disk drives by the 20-percent discount he had determined to be the reasonable transfer price for the disk drives Seagate Scotts Valley purchased from Seagate Singapore. He classified the result as the “value of marketing”, all of which respondent then reallocated to Seagate Scotts Valley under section 482 as reasonable compensation for the marketing services which Seagate Scotts Valley rendered to Seagate Singapore during the years in issue.

The transfer price reallocations in the notices of deficiency for Seagate Singapore-produced disk drives Seagate Scotts Valley sold are as follows:

Year Total adjusted sales 1 20-percent discount

1984 $49,735,000 $9,947,000

1985 158,745,000 31,749,000

1986 408,933,000 81,787,000

1987 938,013,000 187,603,000

The calculations of the offset respondent, in effect, allowed Seagate Scotts Valley for Seagate Singapore’s direct marketing activities are as follows:

Year Total direct sales 1 percent of total direct sales

1984 $23,874,000 $239,000

1985 99,360,000 994,000

1986 175,364,000 1,754,000

1987 417,869,000 4,179,000

3. Petitioner’s Experts

a. Mr. Holdren

Mr. Holdren prepared a comparable uncontrolled pricing study for the fiscal years 1984 through 1987, in which he compared the prices and terms of sale, per disk drive model, of disk drives Seagate Singapore sold to unrelated third parties to the prices and terms of sale, per disk drive model, of disk drives Seagate Singapore sold to Seagate Scotts Valley.

Mr. Holdren analyzed Seagate Singapore’s monthly intercompany sales summaries and unrelated customer sales databases to determine Seagate Singapore’s weighted average net sales prices for disk drives, by disk drive model number, to Seagate Scotts Valley and to unrelated customers. He also tested statistical samples of Seagate Singapore’s related and unrelated third party sales invoices against its sales summaries and sales databases, and reconciled Seagate Singapore’s sales summaries and sales database to Seagate Singapore’s financial statements and to Seagate Scott Valley’s consolidated workpapers and financial statements.

Based on his analysis, Mr. Holdren concluded that Seagate Singapore’s intercompany and third party disk drive net sales and Seagate Scotts Valley’s disk drive net sales were as follows:

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Mr. Holdren concluded that it was not necessary to adjust Seagate Singapore’s average uncontrolled sales prices for differences in freight terms, bad debts, payment terms, geographic market, volume pricing, or level of market to make the uncontrolled sales prices comparable to Seagate Singapore’s average controlled sales prices. He concluded that no relevant differences existed between Seagate Singapore’s uncontrolled sales and its controlled sales with respect to freight terms or bad debts. He further concluded that Seagate Scotts Valley received favorable payment terms relative to Seagate Singapore’s unrelated customers and, consequently, the differences in payment terms did not explain the existing price differential between controlled and uncontrolled prices. Seagate Singapore sold disk drives to all regions of the world. Mr. Holdren concluded that no CUP adjustment was required for differences in geographic markets because differences in prices to various geographic markets did not explain the existing price differential. He further concluded that no CUP adjustments were required for volume pricing or level of market because the nature of the differences in those two items between the controlled and the uncontrolled sales did not explain the existing price differential. Mr. Holdren explained that the reason he concluded that no CUP adjustment was needed for level of market was that he observed prices which showed no instances where OEM customers consistently paid a significantly lower price; in some cases, distributors paid prices as low as or lower than the OEM customers.

Mr. Holdren concluded that the difference in warranty terms between intercompany sales and third party sales was the only difference in circumstances that required an adjustment to Seagate Singapore’s average uncontrolled sales prices. To adjust for the differences in warranty terms, Mr. Holdren decreased the average uncontrolled sales prices by amounts ranging from $4 to $11.38, depending upon the disk drive model.

Mr. Holdren calculated the following average prices for intercompany sales and the adjusted average prices for third party sales for the following disk drive models:

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For selected third party customers, Mr. Holdren’s report reflects the following average net sales prices paid to Seagate Singapore for the following disk drive models (including the highest and the lowest average net sales price paid by customers for each disk drive model Mr. Holdren listed):

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All sales of the ST412 disk drive model detailed in Mr. Holdren’s report for the fiscal years ended 1984 and 1987 are listed above. For the fiscal year ended 1984, sales of only the ST412 disk drive model are detailed in Mr. Holdren’s report.

Mr. Holdren concluded that, if Seagate Scotts Valley had purchased disk drives from Seagate Singapore at the average sales prices Seagate Singapore charged its unrelated customers for each model, as adjusted for the difference in warranty terms, Seagate Scotts Valley would have paid Seagate Singapore $6,056,283, $24,930,275, and $109,930,918 more for fiscal years ended 1984, 1986, and 1987, respectively, and $2,729,026 less for fiscal year ended 1985, for an aggregate decrease in income for Seagate Scotts Valley of $138,188,450. 9 Mr. Holdren concluded further that, if his analysis had been made on a quarterly basis rather than an annual basis, the aggregate price differential decrease would be $153,344,701.

Additionally, Mr. Holdren compared the average sales prices Seagate Singapore charged its three highest volume unrelated customers to the average sales prices it charged Seagate Scotts Valley. He concluded that Seagate Scott’s Valley purchased disk drives from Seagate Singapore at lower prices relative to the average sales prices to the three highest volume unrelated customers, as adjusted for the warranty differences, in the aggregate amount of $131,334,485.

Mr. Holdren further compared the average sales prices Seagate Singapore charged its unrelated distributors to the average sales prices it charged Seagate Scotts Valley. He concluded that Seagate Scotts Valley purchased disk drives from Seagate Singapore at lower prices relative to the average sales prices charged to the unrelated distributors, as adjusted for warranty differences, in the aggregate amount of $143,814,204.

Mr. Holdren concluded that, for each disk drive model, the average sales price charged to all unrelated customers of that model, as adjusted for warranty differences, represents the most reasonable price for his comparable uncontrolled price (cup) analysis.

b. Mr. Broadhurst

Mr. Broadhurst prepared models analyzing disk drive profitability for the disk drives Seagate Singapore and Seagate Scotts Valley produced and sold to unrelated third parties and the disk drives Seagate Singapore produced and sold to Seagate Scotts Valley. He analyzed the disk drive models for which Mr. Holdren identified adequate cost-related information using a variation of the resale price method.

First, for each disk drive model included, Mr. Broadhurst computed Seagate Singapore’s and Seagate Scott Valley’s gross margins per unit by subtracting the average unit cost of each model from the average unit sales price of that model, as reflected in Mr. Holdren’s report. Next, for each such disk drive model analyzed, he computed Seagate Singapore’s and Seagate Scotts Valley’s gross margin percentages per unit by dividing the calculated gross margin per unit by the average unit sales price. Mr. Broadhurst summarized average material, labor, overhead, and total unit costs (the average unit cost) by disk drive model from existing cost accounting information for Seagate Singapore and Seagate Scotts Valley. He adjusted Seagate Singapore’s overhead costs on intercompany sales to remove the per-unit intercompany warranty cost.

Mr. Broadhurst computed the following gross margin percentages based on sales for the following disk drives produced by Seagate Singapore and Seagate Scotts Valley:

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Mr. Broadhurst also computed, on a per-drive basis for the disk drives Seagate Scotts Valley purchased from Seagate Singapore, pro forma transfer prices that Seagate Scotts Valley would need to achieve gross margins of 5 percent, 10 percent, 15 percent, and 20 percent. Mr. Broadhurst used the companies’ sales data bases for the computation. Mr. Broadhurst listed only disk drive models with both intercompany (controlled) and third party sales in the same fiscal year. He obtained a summary of the comparable Seagate Singapore to Seagate Scotts Valley intercompany and Seagate Scotts Valley resale transactions, by disk drive model, for all disk drive models sold by Seagate Scotts Valley to trade customers and purchased from Seagate Singapore. He then computed Seagate Scotts Valley’s actual gross margin resale percentages for the disk drive models as the difference between the Seagate Singapore average intercompany sale price and the Seagate Scotts Valley average third party sale price for the disk drive model divided by the Seagate Scotts Valley average third party sale price for the disk drive model. Next, Mr. Broadhurst computed Seagate Scotts Valley’s pro forma gross margin resale percentages per disk drive model by multiplying 1 minus the pro forma gross margin percentage (5 percent, 10 percent, 15 percent, or 20 percent) by the Seagate Scotts Valley average sale price for that disk drive model. For example, 1 minus 5 percent or 95 percent times Seagate Scotts Valley’s average sale price equals the gross margin of 5 percent.

As computed by Mr. Broadhurst, the actual resale gross margin percentages realized by Seagate Scotts Valley on disk drives purchased from Seagate Singapore are as follows:

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4. Respondent’s Experts

a. Dr. Clowery

For purposes of the transfer pricing issue relating to disk drive sales, Dr. Clowery calculated Seagate Scotts Valley’s gross profit earned on sales of the disk drives during the years in issue, applying consistent accounting treatment of similar items. Dr. Clowery calculated gross profit by subtracting “allocated” cost of sales from net sales (total sales revenue less returns and allowances, volume price breaks, and other adjustments).

Dr. Clowery applied his understanding of consistent accounting treatment, based on transactions as recorded by Seagate Scotts Valley, to calculate the gross profit for Seagate Scotts Valley for the years in issue, in accordance with those income statements. Then, he considered further adjustments which he could make to those results to calculate alternative gross profit amounts for Seagate Scotts Valley.

First, Dr. Clowery calculated Seagate Scotts Valley’s gross profit according to Seagate Scotts Valley’s income statements, which he allocated to disk drives manufactured by Seagate Scotts Valley and by Seagate Singapore and sold by Seagate Scotts Valley. Dr. Clowery used Seagate Scotts Valley’s monthly sales journal entries in the general ledger to identify the following units and dollar values of sales by Seagate Scotts Valley of disk drives manufactured by both Seagate Scotts Valley and Seagate Singapore: 10

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Then, Dr. Clowery used the relative sales values of the disk drives manufactured by Seagate Scotts Valley and Seagate Singapore to allocate adjustments to sales identified in Seagate Scotts Valley’s general ledger to derive net sales for the disk drives manufactured at each location. Next, he calculated the cost of sales for the Seagate Scotts Valley and Seagate Singapore-manufactured disk drives.

Dr. Clowery defined cost of sales as the sum of the direct and indirect costs incurred in the production of the products sold to customers. Dr. Clowery obtained the cost of sales data from the details supporting Seagate Scotts Valley’s monthly cost of sales journal entries, which separately identified amounts for disk drives manufactured by Seagate Scotts Valley and Seagate Singapore. Seagate Scotts Valley’s cost of sales journal entries separately classified amounts for materials, labor, overhead, and Singapore materials. Dr. Clowery added the amounts in the Singapore labor, overhead, and gross profit accounts to the other direct cost of sales amounts for the disk drives manufactured by Seagate Singapore to derive a total cost of materials, labor, and overhead.

In reviewing other direct cost of sales accounts which generally are added to materials, labor, and overhead to arrive at direct cost of sales (such as price ,and efficiency variances, scrap, and freight), Dr. Clowery identified two items which he concluded related specifically to disk drives manufactured by Seagate Singapore. He treated the costs relating to those two items (freight and import duties, net of drawbacks) solely as costs of the Seagate Singapore-manufactured disk drives. Dr. Clowery allocated the remaining identified direct costs between the Seagate Scotts Valley- and Seagate Singapore-produced disk drives on the basis of relative sales values. He also allocated on the basis of relative sales value other adjustments to cost of sales identified in Seagate Scotts Valley’s books and records.

Next, also on the basis of relative sales value, Dr. Clowery allocated to the disk drives manufactured by Seagate Scotts Valley and Seagate Singapore, Seagate Scotts Valley’s indirect costs of sales, after certain adjustments including adjustments to conform the total indirect costs with the indirect costs of sales reflected on Seagate Scotts Valley’s consolidated income statements. The total of the direct and indirect costs of sales equals the total cost of sales reflected on Seagate Scotts Valley’s consolidated income statements.

Finally, Dr. Clowery subtracted the total cost of sales from net sales to derive the gross profit of the disk drives according to the consolidated income statements, as allocated between the disk drives manufactured by Seagate Scotts Valley and Seagate Singapore.

Following the allocations described above, Dr. Clowery calculated Seagate Scotts Valley’s gross profit (GP) from the sale of disk drives per the consolidated income statements to be as follows:

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Dr. Clowery’s calculations reflect the following GP percentages relating to sales of disk drives by Seagate Scotts Valley according to Seagate Scotts Valley’s consolidated income statements, as allocated to disk drives manufactured by Seagate Scotts Valley and Seagate Singapore:

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Dr. Clowery observed that Seagate Scotts Valley had reduced its cost of sales by the R&D payment Seagate Singapore made to Seagate Scotts Valley (one-half of the total costs included in the R&D cost-sharing amount (see infra Issue 8), minus one-half of the R&D expense incurred by Seagate Singapore). He concluded that the R&D payment should have been treated as a reduction in Seagate Scotts Valley’s R&D expense. Consequently, Dr. Clowery reduced Seagate Scotts Valley’s cost of sales by the amount of the R&D payment and, instead, added the corresponding amount to the R&D component of Seagate Scotts Valley’s SG&A. Dr. Clowery also reduced Seagate Scotts Valley’s cost of sales and increased its R&D expense by certain departmental costs which he concluded were included in the R&D cost-sharing calculation but not transferred out to the R&D expense classification.

Following the adjustments described above, Dr. Clowery calculated Seagate Scotts Valley’s GP from the sale of disk drives to be as follows:

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The GP percentages for Seagate Scotts Valley relating to the sale of disk drives based on GP as adjusted by Dr. Clowery are as follows:

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b. Dr. Frisch

Dr. Frisch formulated an opinion as to the transfer prices that an unrelated U.S. distributor would have paid to Seagate Singapore for the disk drives.

In formulating his opinion, Dr. Frisch compared the adjusted gross profit for Seagate Scotts Valley, as calculated by Dr. Clowery, to the gross profit margins reported by certain independent distributors. He concluded that the gross profit margins of the independent distributors approximated a reasonable range for the gross profit margin Seagate Scotts Valley would have earned on the resale of the Seagate Singapore-produced disk drives had Seagate Scotts Valley been dealing with Seagate Singapore at arm’s length. Dr. Frisch then applied that estimated gross profit margin to Seagate Scotts Valley’s selling prices for the disk drives produced by Seagate Singapore to calculate arm’s-length transfer prices.

To locate his comparable companies, Dr. Frisch first considered Seagate Scott Valley’s functions, responsibilities, risks, and method of doing business in reselling the Seagate Singapore-produced disk drives. Then, he looked for information about independent resellers performing similar functions and selling similar products.

Dr. Frisch could not locate any independent distributor that performed precisely the same functions under the same circumstances as Seagate Scotts Valley. He concluded that none of the independent distributors he found were on the same level of market as Seagate Scotts Valley; they generally were Seagate Scotts Valley’s customers. Nonetheless, Dr. Frisch concluded that, if the independent distributors performed similar levels of functions, assumed similar amounts of risks, and otherwise operated under similar circumstances, their gross margins might serve as valid comparables for Seagate Scotts Valley. His next step was to consider methods for dealing with the differences in the functions and circumstances between Seagate Scotts Valley and the independent distributors.

For his comparables, Dr. Frisch looked for companies which were primarily distributors of computer products, computer systems, or computer peripherals or closely related products; i.e., companies distributing products that were likely to be used in conjunction with disk drives and, therefore, likely to be sold to the same customers and subject to similar market forces as Seagate Scotts Valley. He also looked for companies which appeared to distribute significant amounts of disk drives; did not engage in manufacturing as a significant activity; engaged in no or only a trivial amount of retail-level activities; were going concerns during Seagate Scotts Valley’s fiscal 1984 through 1987 period and neither started up nor ceased their operations during those years; and filed public statements with the SEC with financial data for at least part of Seagate Scotts Valley’s fiscal 1984 through 1987 period. As long as the company was not a startup operation, Dr. Frisch used the years for which data was available. For the comparables, Dr. Frisch considered companies classified under Standard Industrial Classification (Sic) codes 5045 (wholesalers of computers and computer peripheral equipment and software) and 5065 (wholesalers of electronic parts and equipment).

Dr. Frisch found 10 companies which satisfied his criteria. He concluded that the functions of selling from an extensive inventory, expeditious order-handling, and granting of credit were important functions for all 10 of the companies. Some of the 10 companies performed a wide range of additional, more technically sophisticated, functions.

In Dr. Frisch’s opinion, if Seagate Scotts Valley had been operating at arm’s length, it would have expected to earn a gross margin at least equal to the gross margin earned by the company performing the least number of functions. He further opined that, at arm’s length, Seagate Scotts Valley may not have expected to earn a gross margin equal to the company which performed the greatest number of functions.

Dr. Frisch noted certain significant differences in the functions performed by the 10 companies and Seagate Scotts Valley. For example, the independent distributors sold to a much larger number of customers but sold in much smaller volumes per order; played a much more modest role in market analysis and planning and in helping their suppliers plan future production; generally did not deal with the large OEM’s and, thus, did not have such major responsibilities for handling complex negotiations over technical specifications and production methods; and experienced less risk from holding inventory but more risk from extending credit. Dr. Frisch concluded that differences in levels of inventory and accounts receivable between the 10 companies and Seagate Scotts Valley were the only significant differences which would require adjustments to render them comparable within the meaning of section 1.482 — 2(e)(3)(ix), Income Tax Regs. 11

Dr. Frisch obtained financial information about the 10 companies from filings they made with the SEC. Where necessary, he combined appropriate fractions of data for overlapping fiscal years to approximate fiscal periods corresponding to Seagate Scotts Valley’s fiscal year. In some instances, the information needed to calculate sales, costs of sales, gross profits, inventories, or accounts receivable for the companies was not available. All 10 of the companies distributed microcomputer or electronic component products as their principal activity. Some of the companies, however, reported more than one type of business segment. The available data did not allow Dr. Frisch to compute gross margins for just the most relevant segment; therefore, except for one such company, the gross margin he computed for each company pertains to the company as a whole.

For each such company, Dr. Frisch first divided the company’s gross profit by sales to determine the unadjusted gross margin. Next, to adjust for differences in inventory, he calculated each company’s level of inventory relative to sales. Dr. Frisch then subtracted Seagate Scotts Valley’s level of inventory from that percentage. Next, he multiplied the difference by the average prime rate during the appropriate fiscal year. Then Dr. Frisch subtracted the result from the unadjusted gross margin. Next, to adjust for differing levels of accounts receivable (as a measurement of the differences in the granting of credit to customers), Dr. Frisch divided each company’s level of accounts receivable by its sales. Then he subtracted from that product Seagate Scotts Valley’s ratio of sales to accounts receivable. He multiplied the result by the prime rate. Finally, Dr. Frisch subtracted that outcome from the company’s gross margin adjusted for inventory differences, yielding the fully adjusted arm’s-length gross margin that reflects differences in inventory and accounts receivable.

Dr. Frisch computed the following adjusted gross margins for the 10 companies (percentage of sales in the relevant segment shown in parentheses):

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Dr. Frisch concluded that, taken as a whole, for the fiscal years ended 1984 through 1987, Seagate Scotts Valley earned a negative gross profit margin from reselling the Seagate Singapore-produced disk drives. In contrast, the 10 companies experienced average gross profit margins ranging between 10 and 25 percent of sales over the same 4-year period. Consequently, Dr. Frisch concluded that Seagate Singapore’s transfer prices to Seagate Scotts Valley for disk drives should be adjusted so that Seagate Scotts Valley’s gross profit margin for each year is at least equal to the gross margin earned by Micro D, which for each such year recorded the lowest gross margin of the companies he identified as comparable to Seagate Scotts Valley.

The resale margin reallocations as calculated by Dr. Frisch 12 are as follows:

Period ending Margin reallocation adjustment

6/30/84 . 1 ($77,302)

6/30/85 . 24,912,466

6/30/86 . 41,643,167

6/30/87 . 16,094,363

Total . 82,572,694

B. OPINION

1. Ultimate Findings of Fact

In the notices of deficiency, respondent did not follow the resale price method described in section 1.482-2(e)(3), Income Tax Regs. The method respondent used to determine the. reallocations relating to the resale of the disk drives in issue relied on incorrect sales revenue figures for the sales of the disk drives and an excessive gross margin percentage. Consequently, petitioner has carried the burden of proving that respondent’s reallocations with respect to the resale of disk drives are arbitrary, capricious, or unreasonable.

2. Analysis of Completed Disk Drive Issue

Neither party has proposed that the cost-plus method would apply under the circumstances present in the instant case to Seagate Scotts Valley’s resale of the disk drives. We agree that the record does not support application of that method. Consequently, we will not discuss it.

Both parties agree that Seagate Singapore generally sold the same disk drive models to Seagate Scotts Valley and to third party customers and that Seagate Scotts Valley resold the disk drives it purchased from Seagate Singapore to third parties. The parties do not agree, however, on the methodology to use to ascertain an arm’s-length price for the subject disk drives.

a. The CUP Method

i. Petitioner’s Position

Petitioner argues that Mr. Holdren’s CUP analysis establishes arm’s-length transfer prices for the disk drives in issue in the instant case. Petitioner contends that Mr. Holdren’s analysis shows that Seagate Singapore sold large volumes of disk drives to numerous unrelated parties at prices substantially higher than the prices at which it sold the identical disk drives to Seagate Scotts Valley. Petitioner further contends that, if Seagate Singapore had charged Seagate Scotts Valley the average price for a disk drive that Seagate Singapore charged unrelated third parties, Seagate Singapore would have received over $138,188,450 more in income from Seagate Scotts Valley than Seagate Singapore actually received.

Petitioner contends that no adjustments to the uncontrolled sales are needed for differences in the level of market because disk drives were commodities and, as with all commodities, a manufacturer’s price to all customers is essentially the same. Petitioner further contends that the facts do not support any realistic volume discount even remotely approaching the prices that Seagate Singapore actually charged Seagate Scotts Valley. Petitioner agrees that volume purchasers tended to receive lower prices, but it contends that the magnitude of such discounts was small. According to petitioner, using the average price at which Seagate Singapore sold disk drives to its three largest unrelated customers produces a setoff of $131,334,495, rather than $138,188,450, or only a 5-percent reduction in the amount of the setoff based on the average price paid by all customers.

Petitioner argues that the CUP method, as applied by its experts, shows that Seagate Singapore actually undercharged Seagate Scotts Valley for the disk drives; consequently, petitioner claims, Seagate Scotts Valley is entitled to a setoff for the amount of that undercharge as provided in section 1.482-1(d)(3), Income Tax Regs. Petitioner, thus, concludes that the intercompany prices for the completed disk drives were not arm’s length, but the prices were not arm’s length only in the sense that Seagate Scotts Valley paid too little, rather than too much for the disk drives.

ii. Respondent’s Position

Respondent contends that Seagate Scotts Valley acted as the distributor in the United States of disk drives manufactured by Seagate Singapore and that Seagate Scotts Valley should have paid transfer prices for the disk drives equal to the prices that an uncontrolled distributor operating at arm’s length would have paid for the disk drives. Respondent argues that Seagate Scotts Valley and Seagate Singapore did not operate at arm’s length in their disk drive transactions. Respondent contends that, under Seagate Scotts Valley’s pricing scheme, Seagate Singapore was treated as a limited risk supplier enjoying a cost-plus pricing methodology through which its prices were not affected by Seagate Scotts Valley’s resale prices. Respondent contends that, for intercompany transactions, Seagate Scotts Valley bore all of the market risk, yet it enjoyed little, if any, of the returns attributable to that risk, and, as a result, Seagate Scotts Valley incurred significant losses on the resale of the Seagate Singapore-produced disk drives.

Respondent argues that the CUP method advanced by petitioner does not derive an arm’s-length price for the disk drives which Seagate Scotts Valley purchased from Seagate Singapore. Respondent argues that Seagate Singapore’s sales of disk drives to Asian and European customers are not comparable to the intercompany sales in issue because those third party sales were in a different geographic market and at a different level of market. Respondent further contends that the use of those third party sales as comparables would result in gross margin losses to Seagate Scotts Valley and would effectively eliminate the resale price method from the regulations.

Respondent offered testimony of Dr. Horst in rebuttal to Mr. Holdren’s CUP analysis. Dr. Horst disagrees with Mr. Holdren’s recommended transfer prices, which are based on a CUP analysis. On the basis of his comparison of prices charged by Seagate Singapore for the ST225 disk drive, Dr. Horst concluded that, if Seagate Singapore had charged Seagate Scotts Valley the same prices which it charged its unrelated customers, Seagate Scotts Valley would have operated at a gross loss in fiscal years ended 1985, 1986, and 1987. He found that situation to be economically untenable.

Dr. Horst concluded that, given the importance of Seagate Scotts Valley as Seagate Singapore’s largest customer, he would expect Seagate Scotts Valley to seek, and Seagate Singapore to offer, some accommodation in the pricing of the disk drives to Seagate Scotts Valley to allow a very critical customer of Seagate Singapore to operate at a profit.

Consequently, Dr. Horst concluded that, under such circumstances, some type of resale price method was the only way to determine what price Seagate Singapore would have charged Seagate Scotts Valley at arm’s length. According to Dr. Horst, a resale price method is the only way to determine what price Seagate Scotts Valley would need to charge in order to continue to play the critical role that it played for Seagate Singapore. In Dr. Horst’s view, differences in geographic markets and levels of market between Seagate Scotts Valley and Seagate Singapore’s other customers justify the rejection of the CUP method in the instant case.

iii. The Court’s Holding as to the CUP Method

The regulations pertaining to sales of tangible property provide that, under the CUP method, uncontrolled sales are considered comparable to controlled sales if the physical property and the circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales. Alternatively, if complete identity of property and circumstances is not present, the uncontrolled sales will nonetheless be considered comparable if either the differences have no effect on price or the differences have a definite and reasonably ascertainable effect on price which can be reflected by a reasonable number of adjustments to the price of the uncontrolled sales. Some of the differences which may affect the price of property are differences in the quality of the product, terms of sale, intangible property associated with the sale, time of sale, and the level of the market and the geographic market in which the sale takes place. Whether, and to what extent, a difference in property or circumstance affects price and whether the difference renders an uncontrolled sale noncomparable depends on the particular circumstances and property involved. Sec. 1.482 — 2(e)(2)(ii), Income Tax Regs. The regulations further provide that, where there are two or more comparable uncontrolled sales susceptible of adjustment, the comparable uncontrolled sale or sales requiring the fewest and simplest adjustments generally should be selected. Sec. 1.482-2(e)(2)(iii), Income Tax Regs. Moreover, uncontrolled sales do not include sales at unrealistic prices, for example, where a member makes uncontrolled sales in small quantities at a price designed to justify a non-arm’s-length price on a large volume of controlled sales. Sec. 1.482-2(e)(2)(ii), Income Tax Regs.

That the disk drives involved in petitioner’s CUP analysis are identical to the disk drives Seagate Scotts Valley purchased from Seagate Singapore is undisputed. Petitioner, however, has not established that the circumstances involved in the uncontrolled sales are identical to the circumstances involved in the controlled sales. To the contrary, the record establishes that the circumstances between the controlled and uncontrolled sales did vary.

Moreover, petitioner has not shown that the differences in circumstances had no effect on price. Indeed, we are persuaded that differences in the circumstances of the sales of the disk drives, for example, volume of sale, level of market, geographic market, and timing of sale, did play some part in determining the uncontrolled sales prices of the disk drives.

Petitioner uses the weighted average sale price for all third party sales of a particular disk drive model as the comparable price for the controlled sales of that model. Petitioner, however, has not established that the net average sale price paid by all unrelated customers for the applicable disk drive model is a comparable uncontrolled price which satisfies the requirements of section 1.482-2(e)(2), Income Tax Regs.

Contrary to petitioner’s contentions, Seagate Singapore’s prices to all of its customers were not essentially the same. The average sale prices third party customers paid to Seagate Singapore for identical disk drive models often differed significantly. For example, during 1984 Seagate Singapore sold the ST412 at average net prices ranging from $440 to $343.83; during 1985, Seagate Singapore sold the ST212 at average net prices ranging from $450 to $219.43; during 1986, Seagate Singapore sold the ST225 at average net prices ranging from $1,334.67 to $246; and during 1987, Seagate Singapore sold the ST225 at average net prices ranging from $341.50 to $211.

Moreover, Seagate Singapore apparently sold the same disk drive models at different prices to unrelated customers that presumably were on the same level of market. For example, during 1984, Seagate Singapore sold the ST412 to IBM (Scotland) for average net sale prices of $410.76 and to Wang (Scotland) at average net sale prices of $440; during 1987 Seagate Singapore sold the ST251 to Co. V for average net sale prices of $361, to Co. U for average net sale prices of $412.05, and to Co. T for average net sale prices of $415.99.

Such disparate prices indicate that a number of factors were involved in setting the prices for the uncontrolled sales. We are given no method, however, to identify and quantify the differences in circumstances among the uncontrolled sales, let alone the differences in circumstances between the uncontrolled sales and the controlled sales. If the effect of the different circumstances on the sale price cannot be quantified, the CUP method cannot be applied. Sec. 1.482-2(e)(2), Income Tax Regs.

Presumably, controlled sales occurred throughout the applicable fiscal year, but it is not clear that disk drive sales to a significant portion of the third party purchasers occurred in a similar manner. The prices for disk drives generally were falling rapidly. Consequently, we would expect that differences in the timing of the sale would have a definite effect on price. Petitioner, however, uses the weighted average net sale prices for uncontrolled sales occurring at unknown times throughout Seagate Scotts Valley’s fiscal year to derive the comparable uncontrolled price for each disk drive model, but makes no adjustments for differences in timing. Nonetheless, petitioner offers no proof establishing that the differences in the timing of the sales had no effect on the disk drive sale prices.

Seagate Scotts Valley offered reduced prices to volume purchasers. Again, the record fails to disclose a method to quantify the effect on price of those volume discounts.

Petitioner has not shown that the differences in circumstances can be reflected by a reasonable number of adjustments to the price of the uncontrolled sales. The average net sale prices alone do not disclose the reasons for the differences in prices; as a result, Mr. Holdren apparently just ignored those differences. There is no evidence that Mr. Holdren attempted to identify among the numerous sales to unrelated customers one or more comparable uncontrolled sales with identical or sufficiently similar circumstances to the controlled sales so that a few simple adjustments to the uncontrolled sale price could be made to arrive at a comparable sale price for the completed disk drives. Sec. 1.482-2(e)(2)(iii), Income Tax Regs. The inference we draw from the failure to identify such comparable transactions is that there are none. Accordingly, we conclude that under the circumstances of the instant case petitioner’s averaging methodology is not a reasonable procedure for deriving comparable prices. Consequently, petitioner has not carried its burden of proving that it is entitled to a setoff against any other section 482 reallocation for the years in issue as a result of the difference in prices Seagate Singapore charged Seagate Scotts Valley and the prices it charged unrelated customers.

b. The Resale Price Method

Under the resale price method, the arm’s-length price of a controlled sale is equal to the applicable resale price reduced by an appropriate markup percentage, with adjustments, if needed. The appropriate markup is computed by multiplying the applicable resale price by the appropriate markup percentage. Sec. 1.482 — 2(e)(3)(i), Income Tax Regs.

The applicable resale price is generally the price at which the property is resold by the buyer in an uncontrolled sale. Sec. 1.482-2(e)(3)(iv), Income Tax Regs. The appropriate markup percentage is the gross profit percentage, relative to sales, earned by a reseller on property that is both purchased and resold in an uncontrolled transaction, if the resale is sufficiently similar to the controlled sale. Sec. 1.482-2(e)(3)(vi), Income Tax Regs.

Characteristics important to the similarity of resales include the type of property involved in the sale; the functions performed by the reseller, examples being “packaging, labeling, delivering, maintenance of inventory, minor assembly, advertising, selling at wholesale, selling at retail, billing, maintenance of accounts receivable, and servicing”; the effect on price of any intangible property used by the reseller in connection with the sale; and the geographic market in which the functions are performed by the reseller. Sec. 1.482-2(e)(3)(vi), Income Tax Regs. Close physical similarity of the property is not required under the resale price method. The important consideration is the probable effect on the markup percentage of any differences between the characteristics involved in the uncontrolled transactions and the characteristics involved in the controlled sales. Id.

In calculating the markup percentage earned on uncontrolled transactions and in applying such percentage to the applicable resale price to determine the appropriate markup, the same elements that enter into the computation of the sale price and the cost of goods sold of the uncontrolled transactions should be used in the computation of the sale price and the cost of goods sold of the controlled transactions. Sec. 1.482 — 2(e)(3)(viii), Income Tax Regs.

In calculating an arm’s-length price under the resale price method, adjustments should be made to reflect material differences between the uncontrolled transactions used to calculate the appropriate markup percentage and the resales of property involved in the controlled sale. Sec. 1.482-2(e)(3)(ix), Income Tax Regs. The differences which require adjustments are those differences in functions or circumstances that have a definite and reasonably ascertainable effect on price. Id.

The uncontrolled transactions must be made within a reasonable time before or after the controlled sales. Generally, for the resale method to be applicable, the reseller may not add more than an insubstantial amount to the value of the property by physically altering the product before resale or by the use of intangible property. Sec. 1.482-2(e)(3)(h), Income Tax Regs. Nonetheless, even where the reseller has added more than an insubstantial amount to the value of the property, the resale price method generally is more appropriate than the cost-plus method when the functions performed by the seller are more extensive and more difficult to evaluate than the functions performed by the reseller. Sec. 1.482 — 2(e)(3)(iii), Income Tax Regs.

In the absence of data on markup percentages of particular sales or groups of sales, the prevailing markup percentage in the particular industry involved may be appropriate. Sec. 1.482 — 2(e)(3)(vii), Income Tax Regs.

i. Respondent’s Resale Price Method

Respondent contends that Dr. Frisch uses the resale price method, described in section 1.482-2(e)(3), Income Tax Regs., in his expert report, to derive the reasonable gross profit margins Seagate Scotts Valley would have earned on the resale of the Seagate Singapore-produced disk drives had Seagate Scotts Valley been dealing with Seagate Singapore at arm’s length. Dr. Frisch then uses those gross profit margins to derive his estimate of reasonable transfer prices for the disk drives Seagate Scotts Valley purchased from Seagate Singapore. Respondent offers the difference between the transfer prices calculated by Dr. Frisch and the transfer prices actually paid by Seagate Scotts Valley for those disk drives as respondent’s adjustment under section 482 pertaining to Seagate Scotts Valley’s resale of the disk drives.

Respondent contends that Dr. Clowery’s adjustments to arrive at the gross margin percentages for Seagate Scotts Valley are mandated by section 1.482 — 2(e)(3)(viii), Income Tax Regs., which requires that, under the resale price method, the same elements be used in computing the cost of goods sold of the controlled and the uncontrolled resale transactions. Dr. Frisch postulates that the gross margin percentages for Seagate Scotts Valley computed by Dr. Clowery were calculated on the same basis and using the same accounting rules as the gross margin percentages Dr. Frisch calculated for the 10 comparable companies because the financial data for the independent companies was taken from the Form 10-K reports and similar SEC filings and Dr. Clowery’s starting point for his calculations is the data Seagate Scotts Valley used in preparing its Form 10-K reports. Dr. Frisch starts with the premise that the SEC requires financial statements filed with it to comply with Generally Accepted Accounting Principles (GAAP). He further believes that GAAP requires companies to calculate cost of goods sold under a full absorption costing method which would incorporate both inventoriable and noninventoriable expenses in cost of goods sold. Dr. Frisch then assumes that all of the companies he selected as comparable complied with GAAP and further that they all allocated to cost of goods sold the identical types of costs that Dr. Clowery allocated in his calculation of Seagate Scotts Valley’s cost of goods sold.

Petitioner’s principal position is that there is no legal or factual support for the allocations Dr. Clowery made to calculate the gross margins Seagate Scotts Valley earned from sales of Seagate Singapore-produced disk drives and Seagate Scotts Valley-produced disk drives; Dr. Clowery’s allocations are unreasonable; and, consequently, Dr. Frisch’s results are unreasonable.

Petitioner argues that Dr. Frisch does not use the resale price method described in section 1.482 — 2(e)(3), Income Tax Regs. Petitioner contends that, had Dr. Frisch followed section 1.482 — 2(e)(3)(i), Income Tax Regs., then multiplied the resale prices Seagate Scotts Valley received from third parties by the gross margins he computed for Micro D, and next compared the results to the intercompany transfer prices Seagate Scotts Valley actually paid to Seagate Singapore, such comparison would show that Seagate Singapore undercharged Seagate Scotts Valley for the disk drives.

Petitioner contends that Dr. Frisch does not apply the appropriate markup percentages to Seagate Scotts Valley’s actual resale prices as required by section 1.482 — 2(e)(3)(vi), Income Tax Regs.; instead, he compares the gross profit margins calculated for Micro D to the gross profit margins that Dr. Clowery estimated Seagate Scotts Valley earned on the resale of disk drives and then Dr. Frisch allocates income to Seagate Scotts Valley in an amount sufficient to equalize Seagate Scotts Valley’s adjusted gross margins with the gross margins of Micro D. Petitioner contends that, without Dr. Clowery’s allocation of Seagate Scotts Valley’s cost of goods sold between Seagate Singapore- and Seagate Scotts Valley-produced disk drives, there would be no section 482 reallocation relating to the resale of the Seagate Singapore-produced disk drives. Petitioner disputes respondent’s position that the regulations require the allocations to cost of goods sold made by Dr. Clowery.

Petitioner argues that section 1.482-2(e)(3)(viii), Income Tax Regs., was never intended to encompass the type or extent of allocations made by Dr. Clowery. According to petitioner, section 1.482-2(e)(3)(viii), Income Tax Regs., should be limited to minor differences between resellers; i.e., freight or packaging expenses.

Petitioner further argues that respondent has not shown that the companies selected by Dr. Frisch as comparables allocated the same type of expenses to cost of goods sold in calculating their gross profit as Dr. Clowery allocated to the Seagate Singapore-produced disk drives or that Dr. Clowery properly allocated to the Seagate Singapore-produced disk drives cost of goods sold expenses relating only to Seagate Scotts Valley’s distribution functions pertaining to those disk drives. Petitioner’s position is that when a company such as Seagate Scotts Valley performs both manufacturing and distribution functions, Dr. Clowery’s formulary approach will inappropriately allocate manufacturing costs to the distribution functions; consequently, if any allocations are required, petitioner contends that they must be made only for precisely identified distribution costs. In sum, petitioner argues that respondent’s proposed adjustment, which is based on allocated manufacturing and distribution costs, does not comply with the resale price regulations.

ii. The Court’s Holding as to Respondent’s Resale Price Method

Because we agree with petitioner that no factual support exists in the record for the allocations made by Dr. Clowery, we do not need to address petitioner’s interpretation of section 1.482-2(e)(3)(viii), Income Tax Regs.

In calculating the gross profit percentage Seagate Scotts Valley earned on the resale of the Seagate Singapore-produced disk drives, Dr. Frisch relied on certain allocations Dr. Clowery made to compute the cost of sales of the Seagate Singapore-produced disk drives. Dr. Clowery made some of those allocations so that the cost of sales for those Seagate Singapore-produced disk drives presumably would contain the same elements as the cost of sales of the products sold by the purported comparable companies. See sec. 1.482-2(e)(3)(viii), Income Tax Regs.

Dr. Frisch relies on Dr. Clowery’s report for information as to the cost of sales Seagate Scotts Valley would have incurred had it simply distributed the disk drives produced by Seagate Singapore. He, however, concedes that if the cost of sales Dr. Clowery allocated to the Seagate Singapore-produced disk drive includes an extensive amount of manufacturing costs, then Dr. Frisch’s selected companies would no longer be comparable since he would be comparing a manufacturer and reseller to resellers only.

Dr. Clowery concedes that he possibly allocated some manufacturing expenses to the cost of sales for the disk drives Seagate Scotts Valley purchased from Seagate Singapore. Indeed, from our review of Dr. Clowery’s allocation method as described in his report, we conclude that, in all probability, Dr. Clowery allocated a significant portion of Seagate Scotts Valley’s manufacturing costs to the cost of sales for the Seagate Singapore-produced disk drives.

Dr. Frisch attempted to restrict his search for comparables to companies which were involved only in distribution functions. Under normal circumstances, a company involved in distribution would not be expected to incur manufacturing-related costs. Consequently, as a result of the allocations to cost of sales made by Dr. Clowery, we are not convinced that the gross profit percentages Dr. Frisch calculated for the 10 companies he selected as comparables constitute a comparable markup percentage for Seagate Scotts Valley’s distribution functions relating to the Seagate Singapore-produced disk drives. See sec. 1.482 — 2(e)(3)(viii), Income Tax Regs.

Consequently, respondent has failed to persuade us that the transfer prices propounded by Dr. Frisch for the completed disk drives are reasonable. Accordingly, we do not address the other arguments advanced by petitioner against the resale price method used by respondent’s experts. 4

iii. Petitioner’s Resale Price Method

Petitioner contends that, to calculate the transfer price of the completed disk drives, respondent used the sale price less purchase price stated in the Co. W distribution agreement to estimate the 20-percent gross margin used in the notices of deficiency. Petitioner contends that, in his report, Mr. Broadhurst used the same method to show that Seagate Scotts Valley generally received a gross margin for the disk drives greater than 20 percent. Petitioner claims that evidence that Seagate Scotts Valley’s actual resale margins exceed the margins earned by Co. X, Co. A, and others, including Seagate Scotts Valley’s sales representatives, shows that a correct application of the resale method would produce no adjustment.

Respondent counters that Mr. Broadhurst’s method renders a “bare bones” cost of goods sold. Respondent contends that Dr. Frisch used financial statements filed with the SEC to obtain his data about the 10 companies he selected as comparables; the SEC requires financial statements to be prepared using the full absorption costing method; under the full absorption costing method other expenses in addition to the purchase price of the product are included in the cost of goods sold of that product; consequently, the cost of goods sold for the products sold by the 10 companies includes other expenses in addition to the purchase price; Mr. Broadhurst does not include other expenses in the cost of goods sold he calculated for the Seagate Singapore-produced disk drives; consequently, Mr. Broadhurst has understated the cost of goods sold for those disk drives and, correspondingly, has overstated the gross margins Seagate Scotts Valley earned on the resale of the Seagate Singapore-produced disk drives. Consequently, respondent argues, it is misleading and inaccurate to compare the gross margins of the 10 companies to the gross margins calculated by Mr. Broadhurst.

Respondent further argues that the notices of deficiency did not apply Co. W’s estimated 20-percent gross margin percentage to Seagate Scotts Valley’s resale prices to calculate the section 482 reallocation relating to the resale of the completed disk drives Seagate Scotts Valley purchased from Seagate Singapore. Instead, respondent contends that the notices of deficiency used Seagate Singapore’s third party prices to attempt to reconstruct the Seagate Scotts Valley resale prices. Additionally, respondent contends that petitioner has not shown that the Co. W, Co. A, or sales representative agreements are comparable transactions to Seagate Scotts Valley’s resales of the Seagate Singapore-produced disk drives.

iv. The Court’s Holding as to Petitioner’s Resale Price Method

As we view the instant case, Mr. Broadhurst’s resale price method also does not conform to section 1.482 — 2(e)(3), Income Tax Regs. Mr. Broadhurst uses average third party prices as calculated by Mr. Holdren to compute Seagate Scotts Valley’s “actual” gross margin percentage. We have already explained why we find such third party prices unreliable. Moreover, petitioner compares the gross margin percentages Mr. Broadhurst calculated for the Seagate Singapore-produced disk drives to the gross margin that Co. X hoped to earn from the resale of Seagate Scotts Valley’s disk drives. Petitioner has presented no evidence of the actual gross margin percentages that Co. X earned during the years in issue. Additionally, the record does not establish the amount of the gross margins earned by Seagate Scotts Valley’s sales representatives or that the gross margins can serve as comparable markup percentages. Although there is some evidence in the record of the gross margins earned by Co. A, we do not rely on that data because there is an indication that for some part of the years in issue Co. A sold products at reduced rates in order to increase Co. A’s market share. Consequently, we reject the resale price analysis propounded by petitioner.

c. The Court’s Holding as to the Arm’s-Length Transfer Prices for the Disk Drives

We have concluded that petitioner has failed to establish that Mr. Holdren’s CUP analysis results in reasonable transfer prices for the Seagate Singapore-produced disk drives. We also have concluded that the record does not contain any basis from which to compute a comparable markup percentage for those disk drives under the resale price analysis advanced by Dr. Frisch or by Mr. Broadhurst. Additionally, we have concluded that the record does not contain information from which we could derive a reasonable transfer price under the cost-plus method described in the regulations. Consequently, we make our best estimate as to the appropriate transfer price for the disk drives on the basis of the available record. Sundstrand Corp. v. Commissioner, 96 T.C. 226, 375 (1991).

We begin by noting that Seagate Singapore’s third party sales of disk drives were substantial in frequency and volume. Seagate Singapore sold the same disk drive models to Seagate Scotts Valley that it sold to third party customers. It would appear reasonable to conclude that the comparable uncontrolled price method should be appropriate for the instant case. The record, however,

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