Sundstrand Corp. v. Commissioner

HAMBLEN, Judge: Respondent determined deficiencies of $1,569,156 and $5,931,159 in petitioner’s 1 Federal income tax for taxable years ending December 31, 1977, and December 31, 1978, respectively (hereinafter sometimes referred to as the years in issue).

STATEMENT OF ISSUES

The issues involved in this case are as follows:

1. Whether respondent’s allocations of gross income under section 482 2 for the years in issue were arbitrary, capricious, and unreasonable.

2. Whether royalties paid to petitioner by Sundstrand Pacific (Pte) Ltd. (hereinafter referred to as SunPac), petitioner’s wholly owned foreign subsidiary located in the Republic of Singapore, for the years in issue for certain intangible property rights SunPac acquired from petitioner were paid at an arm’s-length consideration under section 482.

3. Whether the prices paid by petitioner to SunPac for certain spare parts sold to petitioner by SunPac during the years in issue were paid at an arm’s-length consideration under section 482.

4. Whether petitioner is entitled to foreign tax credits under section 901 for the years in issue for Singapore income taxes imposed on royalties paid to petitioner by SunPac for those years.

5. Whether petitioner, a publicly held manufacturing corporation, is subject to the increased interest of section 6621(c); 3 more specifically, whether there has been a “valuation overstatement” in each year as described in section 6621(c)(3)(A)(i).

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts, the supplemental stipulation of facts, and the attached exhibits are incorporated herein by this reference.

I. BACKGROUND

A. In General

Sundstrand Corp. is a Delaware corporation with its principal offices in Rockford, Illinois. During the taxable years in issue, petitioner was a public corporation whose stock was traded on the New York Stock Exchange, the Midwest Stock Exchange, and the Pacific Stock Exchange. During taxable years 1977 and 1978, petitioner and its consolidated subsidiaries maintained their books and filed their Federal income tax returns on the accrual method of accounting, using a calendar year.

Petitioner was incorporated in 1910 as an amalgamation of two Rockford-based machine tool companies. Petitioner’s two original product lines were machine tools and hydraulic equipment.

During 1977 and 1978, petitioner manufactured and sold products in three broad product areas: (1) Power transmission, (2) heat and fluid handling, and (3) advanced technology. The power transmission line includes transmissions and fuel pumps for nonaviation vehicular and industrial applications. The heat and fluid handling line includes refrigeration units, compressors, and pumps for various industrial applications. The advanced technology line includes aviation and nuclear power components and machine tools. 4

Petitioner’s advanced technology group is responsible for the aviation division. Petitioner’s advanced technology group manufactures a number of aviation products, including, among other things, constant speed drives (hereinafter referred to as CSD’s), see infra, generators, and controls; electric motors to drive pumps, fans, compressors, and actuators; pumps; engine start systems; air turbine motors; primary and secondary flight controls consisting of power drive units, gearboxes, linear and rotary actuators, and asymmetric and torque-limiting brakes for commercial and military aircraft and the space shuttle; auxiliary power units; missile and space vehicle power systems to supply hydraulic, electrical, or pneumatic power; digital flight data recorders; cockpit voice recorders; digital avionic systems; ground proximity warning systems; stall warning systems; anti-ice systems; environmental control systems; movie and stereo music entertainment systems; and refrigeration systems for galleys and water coolers.

In 1977 and 1978, petitioner’s aviation division consisted of four product groups: (a) Electric power, (b) mechanical, (c) energy, and (d) nonproprietary products. The electric power division’s principal product line for those years was the CSD. This case involves intercompany transfers of aviation parts which are component elements of the CSD.

. Internal reports prepared by petitioner for 1977 and 1978 show the following financial information for the aviation division:

1977 1978 (rounded) (rounded)

Net sales

Aviation division $197,459,299 $202,697,381

Electric power 95,602,807 100,024,291

CSD’s 94,079,416

CSD’s-commercial 54,768,192

CSD’s-military 38,024,583

Gross profit

Aviation division 63,134,426 52,547,719

Electric power 46,749,110 37,467,642

CSD’s 46,104,306

CSD’s-commercial 18,443,813

CSD’s-military 15,967,530

Net earnings before taxes

Aviation division 7,276,206 (791,151)

Electric power 5 31,469,801 19,234,513

CSD’s 32,090,582

CSD’ s-commercial 7,878,933

CSD’s-military 9,519,823

B. The CSD

During World War II, the General Electric Co. (hereinafter referred to as General Electric) was the system manager and did the system testing for the U.S. Air Force’s B-36 aircraft program: The B-36 program began production in 1946. Petitioner,- as a subcontractor of General Electric, was the hydraulics manufacturer for the B-36. The B-36 was a large bomber which needed a great deal of electric power. This power had to come from the shaft of the aircraft engine. Since the engine runs at different speeds, such as at takeoff and landing, to get a constant frequency out of the generator 6 a device had to be interposed between the aircraft engine and generator to drive the generator at a constant speed regardless of the speed of the engine. Petitioner designed and developed the CSD for this purpose. General Electric designed the generator and its controls as well as the governor for the CSD.

Petitioner has manufactured the CSD since 1946. The first commercial applications of petitioner’s CSD’s were in the Douglas DC-8 and the Boeing 707 aircraft programs which began production in 1956. Petitioner does not hold any patents on the design of the CSD or CSD parts but does hold some patents on the manufacturing process for CSD parts. The record does not disclose the extent or value of any such patents.

The BOE60 application is a CSD model used on certain Boeing 707 and 727 aircraft. The total number of piece parts in a BOE60 CSD unit is 1,047. Of these, petitioner or its subsidiaries manufacture 249 parts (23.8 percent); subcontractors manufacture 482 parts (46 percent) to petitioner’s specifications; and others manufacture 316 parts (30.2 percent) to industry standards. The parties have stipulated that these numbers, and the percentage in each category, are typical of all petitioner’s CSD units manufactured and sold during 1977 and 1978.

1. Operation

An aircraft’s engines are the primary power source in jet aircraft. In addition to providing the flight power, the engines also run the aircraft’s generators which produce the electrical power for the aircraft. A CSD is a hydromechanical transmission mounted on an aircraft’s jet engine which takes a variable input speed from the engine gearbox and converts it to a constant output speed to power the aircraft’s generator. The major functional units of the CSD are the differential, the hydraulic unit, and the governor. They work together to transfer the torque provided by the engine to the generator at a controlled, constant speed. Each engine pod of the aircraft contains one engine, one CSD, and one generator. The CSD prevents, for example, the airplane’s lights from brightening as the engines are revved.

A hydraulic differential drive transmits power from the engine to the generator by hydraulics. Between 1946 and 1961, petitioner produced hydraulic differential CSD’s. The hydraulic differential CSD, however, requires an overhaul every 500-1000 flight hours and its weight and size make it unattractive for utilization on the commercial jet aircraft which began production in the late 1950s.

In 1959, variable speed constant frequency (hereinafter referred to as VSCF) technology emerged as a serious competitor to petitioner’s CSD. The VSCF converts the variable frequency produced by the generator to a constant frequency by electrical means.

Until 1960, petitioner’s hydraulic CSD’s were the best products on the market for jet aircraft. However, petitioner recognized the limitations of its hydraulic CSD and, in 1960, undertook an ambitious development program to redesign its CSD to meet the VSCF threat. Petitioner’s development efforts produced, in 1961, the axial gear differential CSD (hereinafter referred to as the AGD CSD). The AGD CSD, a hydraulic differential device, relies primarily on mechanical parts rather than hydraulics to transmit power from the engine to the generator. The first AGD CSD was ordered in 1961.

The AGD CSD revolutionized hydromechanical transmission technology by establishing new standards for weight, size, reliability, and performance. The AGD CSD improved reliability by increasing the unit’s operating time between overhauls. It reduced weight and size. Moreover, the AGD CSD improved efficiency due to the efficacious power path of the differential gear set.

The development of the integrated drive generator (hereinafter referred to as the IDG) in 1968 also helped petitioner stave off the advent of the VSCF. The IDG is a refinement of the AGD CSD. It employs most of the principles of the AGD CSD but has a better method of oil-cooling the generator so that the CSD and the generator are more intimately wedded to each other. It also makes a further reduction in the size and weight of the package.

Since developing the CSD in the late 1940s, petitioner has been selected as the transmission contractor on substantially all Western commercial and military jet aircraft programs. Of the CSD’s manufactured in the United States starting with year ordered 1946 and ending with year ordered 1978, there were 103 programs or applications for the CSD; Sundstrand was selected for 88 of those applications.

The AGD CSD commenced the ascendancy of petitioner as a dominant manufacturer and seller worldwide of CSD’s for aircraft jet engines. After 1959, virtually every competitive airframe contract pitted petitioner’s AGD CSD against the VSCF system. Petitioner’s CSD’s were selected for most of the airplane programs between 1959 and 1978. After approximately 1964, other competitors’ CSD’s became somewhat obsolete because of petitioner’s AGD CSD. Between 1963 and 1978 there were 55 aircraft applications of the CSD manufactured in the United States; Sundstrand was selected for all but one of these applications.

In the early 1970s, however, petitioner’s CSD unit was replaced by a VSCF system on the A-4 airplane, a moderately small military application. Moreover, in 1977, McDonnell Douglas, at the urging of the U.S. Navy, selected a VSCF system on the F-18 airplane program, a very large application.

Evans W. Erikson (hereinafter referred to as Mr. Erikson), at the time of the trial petitioner’s chairman of the board and chief executive officer, attributes petitioner’s success in the CSD market to petitioner’s willingness to invest heavily in research and development on new and improved CSD’s, which no other company was willing to do. Indeed, according to Mr. Erikson, since 1959, petitioner has spent more money on the continued, development of CSD’s than all of its competitors combined.

2. Marketing CSD’s

The CSD primary market consists of unit sales to airframe manufacturers such as Boeing and McDonnell Douglas for installation on new aircraft, generally called original equipment manufacturer units (hereinafter referred to as OEM units). The competitive selection process begins as much as 2 years before the airframe manufacturer makes the final decision to produce the aircraft. At this stage, petitioner (as would its competitors) provides the manufacturer with information concerning its CSD unit. Additionally, petitioner works with the airframe manufacturer to determine the program’s requirements. After the airframe manufacturer identifies the company selected to build the engine for the program, petitioner works with the engine company as well. Thus, at the end of the first stage of the competitive selection process, petitioner has a reasonably complete technical definition of its proposal should the airframe manufacturer decide to proceed with construction of that airplane program.

The second stage in the selection process begins when the airframe manufacturer commits to build the aircraft. At this time, the airframe manufacturer issues a “request for proposal” to the various OEM unit manufacturers. Petitioner defines the engineering aspects of the unit in detail and extensively reviews the customer’s specifications to satisfy all design requirements. Moreover, petitioner analyzes its costs to supply the particular aircraft program.

3. Pricing CSD’s

Petitioner groups its expected program costs into (1) nonrecurring costs and (2) recurring costs. Nonrecurring costs are one-time startup costs associated with the unit’s development. Nonrecurring costs include development and qualification costs, certification and flight testing costs, special tooling, and test equipment. Recurring costs are costs associated with the production and installation of the OEM units. Recurring costs include all material, labor, and overhead costs as well as an allocation of general and administrative, marketing, and corporate expenses.

Petitioner includes in. its cost consideration projected product support and warranty costs, which generally amount to approximately 3 to 5 percent of the sales price. As part of the original contract, petitioner provides a training program associated with the installation of the OEM unit and also provides periodic training classes for the airlines.

Once petitioner has quantified its nonrecurring and recurring costs, petitioner determines the OEM unit bid price. Petitioner prices its OEM units to recover both recurring and nonrecurring costs. Additionally, petitioner includes in its program bid what it considers to be a reasonable profit on each particular unit.

In determining the price, petitioner considers the number of units the airframe manufacturer specifically asks petitioner to build and the period of time the airframe manufacturer asks petitioner to commit to a firm, fixed price to satisfy the first 3 or 4 years of the manufacturer’s production run (the initial launch period). At the end of the initial launch period, petitioner and the airframe manufacturer enter into a new contract, repricing the OEM units for an additional 3 years. This repricing process can be repeated as many as seven to eight times during the life of a program.

The severity of the competition for the program directly affects petitioner’s OEM bid price. Petitioner typically prices its OEM units at a level which makes them immediately profitable to petitioner. 7 On some aircraft programs, airframe manufacturers have selected petitioner as the CSD OEM manufacturer even though petitioner was not the lowest bidder.

C. Spare Units and Spare Parts

1. Sales

In addition to manufacturing and selling OEM units, petitioner also sells spare CSD units (hereinafter referred to as spare units) and spare parts. A spare unit is any unit not originally installed in the airplane by the airframe manufacturer. Spare unit customers are primarily commercial airlines who place spare units strategically throughout their flight routes in the event of a CSD failure. Some spare units are sold directly to the airframe manufacturer for resale as either part of a general provisioning package with the airline or as a quick-change engine kit.

Petitioner’s commercial products support department is responsible for petitioner’s sales of spare parts and spare units. This activity consists principally of order administration and order processing functions. No marketing or selling activities Eire underteiken to sell spare parts and spare units in the commercial market. Throughout the 1970s, petitioner’s product support had an extremely poor reputation. During this time, petitioner was 50-percent delinquent in delivering spare parts.

Historically, petitioner generally supplies the spEtre parts for the units on which it has the CSD contract. Once an airfrEime manufacturer selects petitioner’s CSD unit for an aircraft, petitioner is virtually assured of the spare unit Emd spare parts market for the life of the airframe program, often for as long as 20 years.

2. Pricing

a. Spare units.

Petitioner sets its spare units price as a function of the OEM unit price. When spare units are first priced for a new program, petitioner usually charges the OEM unit price plus 50 percent. Petitioner reviews the pricing of the spare units once a year or so and slowly increases the price to as much as two to two Emd one-half times the price of the OEM unit. During the early 1970s, the spare unit price was 150 to 200 percent of the OEM unit price. By the late 1970s, petitioner increased that ratio to 200 to 250 percent of the OEM unit price. Petitioner does not have published catalog prices for spare units. It quotes these prices by telephone. However, at any given time all customers are charged the same price for the spare units.

b. Spare parts.

Petitioner publishes an annual catalog (the spare parts price list) which states the sales prices for petitioner’s spare parts (hereinafter referred to as the catalog price). Petitioner sells substantially all of the commercial spare parts shown in the spare parts price list at 100 percent of the catalog price at the time the order is placed regardless of whether the customer is an airframe manufacturer or an airline. 8

Petitioner arrives at the spare parts prices in two ways. First, it looks at the catalog prices for similar kinds of parts. Then petitioner compares the total breakdown of the parts that go into a spare unit to ensure that the total cost of the sum of the spare parts which would comprise an assembled CSD does not exceed the price of a spare unit after taking into consideration the cost of assembling and testing the spare unit.

II. THE STARTUP OF CSD OPERATIONS AT SUNPAC

A. Background

Up to 1974, the aviation division had two manufacturing facilities: Rockford, Illinois, and Denver, Colorado. The Denver facility was the primary CSD parts manufacturer for the aviation division. The Rockford facility primarily was the manufacturer of the outside housings for CSD’s. It also was responsible for the final assembly of the CSD’s and testing of petitioner’s CSD products.

In 1974, petitioner’s Rockford and Denver CSD facilities operated at full capacity or what petitioner’s management considered to be full capacity. 9

In 1974, petitioner believed that there would be an expansion in the commercial airline and military aircraft business in the late 1970s and the early 1980s. Petitioner further believed that there would be a corresponding upswing in its CSD business. Petitioner needed extra capacity to meet the projected increased demand.

Petitioner believed that its plants in Rockford and Denver already were too large. Therefore, it did not want to expand those facilities further to accommodate its anticipated increased production. Petitioner needed to look elsewhere for future possible expansion. It examined its operations in Singapore for this purpose because of the lower labor rates there, certain tax and other incentives offered by the Republic of Singapore, and the availability of English-speaking workers.

SunPac was incorporated under the laws of the Republic of Singapore on October 20, 1971. SunPac is and has always been a wholly owned subsidiary of petitioner. During the taxable years in issue, SunPac had a November 30 fiscal year and maintained its books on an accrual method of accounting.

Petitioner organized SunPac to manufacture parts and assemblies for a pneumatic sander product line sold by petitioner’s machine tool division. 10 SunPac began its manufacturing operations in a leased facility in 1972. As of March 31, 1974, SunPac had accumulated losses of S$334,899. 11 SunPac’s pneumatic sander operation was a very low-technology facility by American standards.

In early 1974, petitioner reorganized its operating units, combining its machine tool division and aviation division into the advanced technology group. Following the reorganization, the advanced technology group assumed operational control of SunPac and its pneumatic sander business.

In April 1974, petitioner’s manager of advanced manufacturing planning, Robert Schaller (hereinafter referred to as Mr. Schaller), prepared a report for Mr. Erikson, at that time the group vice president of petitioner’s advanced technology group. Mr. Schaller wrote the report preparatory to Mr. Erikson’s forthcoming visit to the Far East, including a stop in Singapore. Mr. Erikson had asked Mr. Schaller to investigate the possibility of SunPac’s subcontracting parts for the aviation division. Mr. Schaller concluded that with additional investment and substantial effort and cooperation from everyone, the Singapore operation could be highly profitable within the year 1975.

Mr. Erikson traveled to the Far East in May 1974 with Kenelm Groff (hereinafter referred to as Mr. Groff), who was in charge of petitioner’s contract administration and product support. In Singapore Mr. Erikson and Mr. Groff visited SunPac’s facility as well as other plants owned by Japanese and American manufacturers. They also met with representatives of the Singapore Economic Development Board (hereinafter referred to as the EDB), various bankers and businessmen, and the U.S. Ambassador. Mr. Erikson was not impressed with SunPac, observing that it produced a poorly constructed product under “garage shop” conditions.

Upon his return from Singapore, Mr. Erikson asked the general manager of the aviation division to have manufacturing personnel prepare a study analyzing the feasibility of manufacturing commercial CSD parts in Singapore. On July 17, 1974, a report on this subject was presented to the advanced technology group management (hereinafter referred to as the July report). The July report was primarily the work of Mr. Schaller and Larry Myers (hereinafter referred to as Mr. Myers), the then manager of manufacturing engineering at petitioner’s Denver, Colorado, facility.

The July report recommended an investment by SunPac of $4.2 million in plant and equipment to make certain CSD parts. It concluded that petitioner could earn a return on the investment of 23.5 percent taking into account tax considerations, with a payout in 5.6 years. The advanced technology group’s management rejected the July report because the rate of return on investment without including tax considerations was considered inadequate. The presenters were ordered to reevaluate the project.

On July 31, 1974, a revised report (hereinafter referred to as the final report) was presented to the advanced technology group’s management. The final report included more CSD parts and required a larger capital investment by SunPac. The final report was based on a capital investment of approximately $5.5 million calculated as follows:

Item 1974 1975 1976 1977 Total

Land and site prep. $384,000 $384,000

Building $300,000 $545,250 845,250

Building equipment Machines and 300,000 279,299 579,299

equipment 278,301 2,474,827 2,753,128

Startup 183,000 183,000 $160,000 526,000

Supplies inventory 50,000 400,000 450,000

Total 384,000 1,111,301 3,882,376 160,000 5,537,677

It calculated a profitability index of 15.2 percent and a payout in 6.5 years without considering the tax consequences and 23 percent and 5.7 years considering the tax consequences.

A revised request for authorization for expenditure prepared in October 1976 reflects the following investment for the SunPac facility:

Item 1974 1975 1976 1977 Total

Capital $1,026,000 $1,096,000 $4,683,471 $560,000 $7,365,471

Expense - - - 183,000 183,000 160,000 526,000

Working funds --- 50,000 400,000 --- 450,000

Total 1,026,000 1,329,000 5,266,471 720,000 8,341,471

The revised request for authorization shows a profitability index of 2.5 percent and a payout of 9.3 years.

The final report projected Singapore sales, including factors for growth and price escalation, for 1975 through 1984 as follows:

Year Projected sales

1975. $1,066,500

1976. 2,435,300

1977. 12,357,200

1978. 18,021,900

1979. 20,667,700

1980. 22,920,900

1981. 25,526,600

Year Projected sales

1982. 28,399,200

1983. 31,530,900

1984. 35,041,300

The advanced technology group’s management and petitioner’s corporate management approved the final report in August 1974. Also in August 1974; petitioner’s management authorized an expenditure of $5,537,677 for SunPac based upon the recommendations and calculations contained in the final report. Petitioner’s board of directors approved the final report in October 1974.

Mr. Erikson recognized that, in order to transfer the CSD technology to SunPac successfully, petitioner would have to have expatriates live in Singapore for a couple of years. Petitioner realized that SunPac would require considerable technical support from petitioner in order to succeed as a CSD manufacturer. Petitioner recognized that its technical personnel would have to supervise, train, and upgrade the Singapore workers’ skills to meet petitioner’s standards. The final report recommended that implementation of all phases be controlled by petitioner’s technical personnel on site in Singapore. According to the final report, technical support would be needed on site for as long as 4 years in the following areas: print interpretation, process and tool liaison, operator machine instruction, supervision instruction, and other.

B. Sunpac Parts Selection

In order to maximize profitability, by increasing technology and its investment in phases, petitioner planned to introduce gradually families of parts at SunPac, thereby progressing from parts with the lowest to the highest technology. The families of parts were carefully selected to optimize performance and minimize the use of special processes. Mature spare parts were selected for which the engineering drawings would change very little.

Petitioner’s manufacturing personnel used petitioner’s commercial spare parts gross report as the universe of potential CSD parts for SunPac to manufacture. The commercial spare parts gross report was a 5-year forecast of commercial parts sales on a part-by-part basis and set forth petitioner’s spare parts requirements for approximately 15,000 parts. After review, the manufacturing personnel identified between 2,500 and 3,000 petitioner-manufactured parts as potential candidates for SunPac manufacture and sale (hereinafter referred to as the parts candidates).

Petitioner’s manufacturing personnel then reviewed the engineering blueprints for each of the parts candidates and excluded from consideration those parts candidates that., also were available by purchase from vendors. The remaining parts candidates were organized into multiple categories based on similarities in manufacturing. In s.um, petitioner identified 1,200 specific parts candidates, which were divided into 33 categories (family classes) based on similarities in the parts’ manufacturing processes. Parts considered had to have a long program life'which would offer petitioner a very forecastable load for the plant at SunPac. Other required characteristics included bulk quantity production and high profit margin potential. Petitioner planned for SunPac to produce only parts which were fully qualified and for which the manufacturing and inspection techniques had been completely proven.

In identifying SunPac’s parts candidates, nine processes used in the manufacture of specific CSD parts were identified that were capital intensive or presented environmental or other special considerations (the special processes). The nine special processes were (a) electron beam welding (EBW), (b) electrical discharge machining (EDM), (c) electrochemical milling machining (ECM), (d) diffusion bonding, (e) lead pot bonding, (f) high pressure flushing and cleaning, (g) general heat treating, (h) general plating, and (i) Gleason die quenching. 12 Three of the special processes — EDM, lead pot bonding, and high pressure flushing and cleaning — were not used in the production of any of SunPac’s parts candidates. Petitioner equipped SunPac with the machinery necessary to perform the general heat treating, general plating, and Gleason die quenching processes around April 1976. During 1977 and 1978, SunPac did not possess the machinery necessary to perform the EBW, ECM, and diffusion bonding processes.

C. Phasing In the Sunpac CSD Operations

The technical study which was part of both the July report and the final report proposed several phases of the manufacturing process at SunPac. In phase I, petitioner intended to have SunPac manufacture parts denominated as “group A.” Group A parts are non-heat-treated parts and have minimal special processes applied to them. Some of the parts are produced from castings or forgings. Group A parts could be started and finished by SunPac.

Phase II anticipated an expansion of the manufacturing facility, including land acquisition.

Phase III and phase IV overlapped and were considered wholly phase III in the final report. Phase III planned for the expansion of the manufacturing capabilities to include those parts contained in “group B.” These parts required relatively simple heat treating or other special processes to be performed in petitioner’s U.S. CSD facilities. Up to 60 percent of the labor content of these parts was performed in the United States.

Phase V provided for the introduction of “group C” parts. Group C parts were sent over from the United States in a semifinished condition (e.g., pistons and blocks) for completion by SunPac. Petitioner forecasted that it would perform up to 60 percent of the labor on group C parts.

During phase VI, petitioner planned to introduce “group D” parts to SunPac. Group D parts would be comprised of between 60- and 100-percent SunPac labor.

Petitioner intended to treat SunPac as one of its suppliers during phases I, II, and III. According to the final report, for phases III, V, and VI more specialized personnel (such as metallurgists, chemists, gear technicians, and precision grinding specialists) would be required on site in Singapore for as long as needed after implementation.

Petitioner anticipated selling SunPac parts as spares as well as using SunPac parts in the manufacture of petitioner’s CSD’s. Petitioner estimated that its internal use of SunPac parts could be up to 50 percent of SunPac’s production. Petitioner intended to purchase all initial SunPac parts and to continue to distribute SunPac parts for a reasonable time until SunPac itself developed the capability to distribute the SunPac parts. Petitioner also intended to maintain dual sourcing capabilities 13 for parts licensed to SunPac to assure airline customers that petitioner would continue to have the ability to source the part domestically in the event that an alternative source became necessary.

Once SunPac’s 1,200 parts candidates were organized into family classes, petitioner’s manufacturing personnel proceeded to determine the types and number of pieces of equipment necessary to SunPac’s operation.

D. Financing SunPac

1. Loans

With the EDB’s assistance, SunPac entered into loan negotiations with the Development Bank of Singapore (hereinafter referred to as the bank). In November 1974, SunPac obtained a S$ll,500,000 term loan from the bank. This loan was subject to an interest rate of 9.5 percent per year and was to be used solely for land acquisition, factory construction, and equipment acquisition and installation. It was repayable in 14 equal 6-month installments, with the first installment due the earlier of 3 years from the date of the first disbursement or December 1, 1977.

SunPac also received a S$3,760,000 line of credit from the bank in November 1974. The line of credit plus any capitalized interest was payable on demand and subject to interest at a rate of 0.5 percent above the prevailing prime lending rate in Singapore or as determined by the bank.

Petitioner guaranteed both loans as a condition of SunPac’s obtaining the loans.

During 1975, the EDB loaned SunPac S$l,500,000 over a 5-year period at an interest rate of 9 percent for SunPac’s training program. Petitioner also guaranteed this loan.

2. Training Grants

Petitioner anticipated that considerable expenditures would be needed beyond any grants given by the Republic of Singapore to train the Singaporean workers in the production of CSD parts. Because of the complexity in manufacturing aircraft quality parts, petitioner realized that in order to obtain a quality system in Singapore which would be acceptable to the FAA, a significant effort would be needed in training the Singaporean workers.

In January 1975, SunPac submitted an industrial training grant proposal (hereinafter referred to as the industrial training grant) to the EDB. The industrial training grant contemplated the training at SunPac’s facility of 115 Singaporean nationals by June 30, 1977. Additionally, in January 1975, SunPac submitted an overseas training scheme proposal (hereinafter referred to as the overseas training grant) to the EDB, requesting that the EDB share equally in the expenses to train four Singaporean nationals at petitioner’s Rockford, Illinois, and Denver, .Colorado, facilities.

On April 23, 1975, the EDB agreed to a maximum financial subsidy of the Overseas Training Grant of S$48,765. In January 1976, the EDB formally approved an industrial training grant of S$867,000.

III. CONSTRUCTING, EQUIPPING, AND STAFFING THE FACILITY

A. The Land-

On November 7, 1974, SunPac entered into an agreement with the Singapore Housing and Development Board which granted SunPac a net ground lease on 9.8 acres in the Bedok industrial park. The lease is for 60 years beginning on December 1, 1974, provided that SunPac constructed its proposed facility on the land within an 18-month period from December 1, 1974, or as extended solely at the discretion of the Housing ' and Development Board. The lease requires a nonrefundable premium payment of S$2,565,312 and an annual license fee of S$12.

B. The Equipment

SunPac acquired the machinery and equipment necessary to its production of CSD parts from three sourpes during 1975 and 1976. First, SunPac transferred to the'new facility a few lathes, drills, and grinders that had'been used in its pneumatic sander operation. Second, petitioner transferred certain retrofitted used equipment to SunPac in exchange for capital stock. Finally, petitioner purchased new or used equipment in the United States which it sold to SunPac at the equipment’s fair market value.

1. Equipment Transferred from Petitioner

In a letter to respondent dated January 6, 1975, petitioner requested a ruling under section 367 that its transfer of used machinery and its associated tools and gages to SunPac in exchange for additional shares of SunPac stock was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes and that no gain or loss would be recognized on the transaction under section 351. In its request for a ruling, petitioner represented the following facts, among others, to respondent:

(1) Payments to petitioner by SunPac pursuant to any technical agreement would be equal to the fair market value of the assistance rendered and/or licenses granted.

(2) Petitioner would not transfer to SunPac any property of which, at the time of the transfer, petitioner was a licensor or lessor, except property of which SunPac was the lessee or licensee.

On April 29, 1975, respondent sent a letter to petitioner regarding the proposed transaction (hereinafter referred to as the ruling). Based on the representations petitioner made to respondent regarding this proposed transaction, respondent ruled that:

(1) The proposed transaction as described by petitioner is not made in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes within the meaning of section 367.

(2) No gain or loss will be recognized to petitioner on the transfer of the property solely in exchange for SunPac’s stock (section 351(a)).

(3) The basis of SunPac’s stock received by petitioner will be the same as the basis in the property exchanged for the stock (section 358(a)(1)).

(4) The basis of the property received by SunPac will be the same as the basis of the property in the hands of petitioner immediately before the exchange (section 362(a)).

In the ruling respondent, among other things, stated the following:

Specifically no opinion is expressed as to the tax consequences of the transaction described in the Agreement. Further, no opinion is expressed as to the tax treatment of the transaction under the provisions of any of the other sections of the Code and Regulations which may also be applicable thereto, or to the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction which are not specifically covered by the above rulings.

Respondent has neither modified nor revoked the ruling since its issuance.

2. Equipment Purchased

SunPac purchased the following equipment from petitioner at fair market value:

1975 1976 1977

(in thousands)

$273 $206 Machinery CO Tp

323 20 Tools and gages ^ CO

416 27 Perishable tools I> CO

Approximately 60 percent of SunPac’s machinery and equipment in 1976 consisted of new equipment.

C. Staffing the Facility and Training the Employees

In 1975, SunPac shut down its pneumatic sanders facility and terminated all its employees. Based on mechanical aptitude and skills tests, SunPac rehired those employees whom it determined could perform the tasks necessary to manufacture aerospace products. SunPac added to this work force by hiring graduates of the EDB technical schools.

To properly train its employees, SunPac established an extensive in-house training program for all factory employees. This training program was based on the training program petitioner used in its U.S. facilities.

The first training sessions began at SunPac in April 1975. Trainees initially received 16 weeks of primary training in machining and allied skills. Graduates of the EDB technical schools received only 12 weeks of initial classroom instruction, however. At the conclusion of the initial training program, the employees were classified as class C operators (i.e., beginning machinists). The employee who received additional classroom and on-the-job training advanced to a class B operator (i.e., intermediate machinist) and then to a class A operator (i.e., skilled machinist). It takes approximately 2 years for a class C operator to achieve class A operator status. Due to the manufacturing skills required to produce CSD parts, it takes 4 to 6 years for any machine operator to achieve optimum productivity.

In 1975, four of SunPac’s employees came to the United States to spend 1 year at petitioner’s Denver facility to learn technical and managerial skills. SunPac planned for these employees to assume supervisory positions in the future.

IV. THE BEDOK FACILITY

During 1975 and 1976, SunPac began to phase in parts in the various family classes based on SunPac’s relative technical expertise and process capabilities. All of SunPac’s 1975 production was dedicated to training.

SunPac commenced operations at the Bedok facility in April 1976. In 1977, the building consisted of a 41,351-square-foot factory and a 9,568-square-foot two-story office complex. In May 1978, SunPac presented to the EDB plans to expand its Bedok facility. The planned expansion would increase SunPac’s total investment in Singapore to approximately S$48,700,000 and expand the facility to 171,801 square feet.

As of December 31, 1977, SunPac employed a total of 220 individuals. The number of employees increased to 276 individuals as of December 31, 1978. The majority of SunPac’s factory employees are graduates of EDB technical schools.

During 1977 and 1978, Mr. Groff, Mr. Myers (at that time SunPac’s managing director), and a solicitor from SunPac’s Singapore law firm comprised SunPac’s board of directors.

A. Organization

SunPac’s managing director is responsible for its day-today operations. In the beginning of 1977, SunPac was organized into seven major operational departments: (1) Manufacturing, (2) manufacturing engineering, (3) quality assurance, (4) production planning, (5) plant engineering, (6) accounting, and (7) personnel. The manager of each department reports directly to the managing director. SunPac added an additional group, the products support group, in 1977.

In 1977, except for the accounting and personnel managers, SunPac’s managing director and department managers were U.S. expatriates. The accounting and personnel managers were Singaporeans. All of the U.S. expatriates had been employed by petitioner before transferring to SunPac. In 1978, three Singaporeans were department managers.

Sundstrand Service Corp., a domestic subsidiary of petitioner, paid the salaries of the U.S. expatriates. Sundstrand Service Corp. charged back to SunPac, on a current basis, 100 percent of the compensation paid to SunPac’s managing director. Sundstrand Service Corp. also charged back to SunPac, on a current basis, a percentage of SunPac’s manufacturing manager’s compensation. The remaining expatriates’ compensation was considered a technical assistance cost recoverable through the 3-percent technical assistance fee, see infra.

1. The Manufacturing Department

During 1977 and 1978, SunPac employed 84 and 116 manufacturing personnel, respectively, in its manufacturing department. SunPac’s manufacturing department performs a full range of manufacturing processes including lathing, milling, drilling, broaching, grinding, heat treating, plating, deburring, honing, and assembly. SunPac manufactures piece parts and a few subassemblies from piece parts that it manufactures in whole or in part.

2. The Manufacturing Engineering Department

By the end of 1978, SunPac employed 26 individuals in its manufacturing engineering department. SunPac’s manufacturing engineering department is responsible for maintaining the facility’s tooling, troubleshooting problems which develop on the shop floor, maintaining the technical packages for the various parts manufactured by SunPac, making process changes to the technical plans, suggesting changes to petitioner regarding the parts, and training employees. SunPac’s manufacturing engineering department, however, may not make changes to the design print (the engineering blueprint).

3. The Quality Assurance Department

SunPac’s quality assurance department is responsible for creating, 14 rewriting, and maintaining the quality manual. SunPac employed 41 quality assurance employees in 1977 and 50 quality assurance employees in 1978. SunPac’s quality assurance personnel activities Eire in addition to the quality control functions performed by SunPac’s manufacturing personnel. SunPac’s quality assurance personnel also perform final inspection on sample parts before the parts are placed in finished inventory.

SunPac reworks or scraps parts it finds are defective. During 1975 and 1976, SunPac experienced a production scrap rate of approximately 35 percent, which fell to 27.1 percent in 1977 and to 15.2 percent in 1978. During 1977 and 1978, SunPac incurred scrap production costs of S$l,675,355 and S$l,105,238, respectively.

4. The Production Planning Department

The production planning department confirms suggested orders from petitioner, releases orders for raw materials to the shop floor, and controls the flow of peirts through the manufacturing process. The production planning depeirtment also is responsible for SunPac’s purchasing activities, shipping and receiving, and preservation packing.

SunPac manufactures parts based on petitioner’s forecast rather than on firm purchase orders placed by petitioner. SunPac directly purchases all manufacturing and office supplies that are available in Singapore. SunPac purchases equipment and tooling available only in the United States through petitioner. SunPac employed 18 people in its production planning department in 1977 and 28 people in 1978.

5. The Products Support Department

In the latter half of 1977, SunPac established a products support department. In 1978, SunPac employed three individuals in its products support department.

B. Materials Purchases

To comply with limitations of the Federal Aviation Administration (hereinafter the FAA) as a condition for SunPac’s receiving parts manufacturer approved certification, see infra, in 1977 and 1978, SunPac purchased all raw materials and components from petitioner. SunPac purchased principally from petitioner barstock, castings, forgings, industry standard parts, and semifinished parts for the cylinder block. SunPac incurred freight and insurance expenses related to these purchases. Singapore did not impose customs duties on the raw materials and semi-finished parts SunPac purchased from petitioner.

SunPac purchased materials based on petitioner’s fore-casted order suggestions. Due to long procurement lead times, SunPac placed its orders for raw materials 6 months before SunPac needed the raw materials for its production. SunPac owned the materials it purchased from petitioner. Petitioner was not required to purchase from SunPac all of the forecasted parts.

Petitioner determined the price it charged SunPac for these materials using a cost-plus price method.

V. APPLICATION FOR TAX RELIEF

A. Relief Available

Pursuant to the Singapore Economic Expansion Incentives (Relief from Income Tax) Act, 1967 (hereinafter referred to as the incentives act), the Government of Singapore grants “pioneer enterprises” certain Singapore tax benefits. A pioneer enterprise’s income may be wholly or partially exempt from Singapore taxation for a period from 5 to up to 15 years depending upon whether it receives a “pioneer certificate,” an “expansion certificate,” and/or an “export enterprise certificate.” The EDB is responsible for evaluating incentive applications made under the incentives act.

1. Pioneer Certificate

To qualify for a pioneer certificate, a company must commit to a fixed capital expenditure of not less than S$1 million. A pioneer enterprise holding a pioneer certificate is entitled to tax relief for a period of 5 years commencing on its “production day.” 15 During this 5-year tax relief period, the pioneer enterprise is wholly exempt from tax on its income arising from production of pioneer products. See part II, secs. 5 and 6 of the incentives act.

2. Expansion Certificate

Existing enterprises that expand their operations in Singapore can qualify for an expansion certificate if the company commits to “new capital expenditure” 16 which exceeds S$10 million. A pioneer enterprise that qualifies for an expansion certificate is exempted from Singapore taxation for up to an additional 5 years commencing on the “expansion day” 17 on the “expansion income” generally in excess of the income derived before the expansion. See part III, secs. 17-19 of the incentives act.

3. Export Enterprise Certificate

To qualify for an export enterprise certificate, a company has to produce an export product approved by the Government of Singapore. An export enterprise generally is entitled to an exemption from Singapore tax on 90 percent of its “export income” in excess of the balance of the “export profit” as determined by statute. This exemption generally is for 5 years or, if the export enterprise is a pioneer enterprise, for 3 years in addition to the 5-year pioneer enterprise tax relief period. However, in specified circumstances, the relief period can be extended to a period aggregating 15 years. See part IV, secs. 20-23, 28-30 of the incentives act.

B. SunPac’s Applications for Tax Relief

On or about August 30, 1974, SunPac, through petitioner, submitted an application for pioneer enterprise status under the incentives act for its proposed CSD operations in Singapore. 18 In addition to the 5-year tax exemption normally granted under a pioneer certificate, SunPac requested a 3-year export enterprise certificate to commence upon the expiration of its pioneer certificate. SunPac also sought to have exempt from tax any payments made by SunPac to petitioner’s advanced technology group for rendering temporary technical and management assistance to SunPac, developing the new plant, and training Singaporean nationals. Moreover, SunPac requested exemption for the payment of reasonable sums “in the nature of royalty fees or the like” to petitioner for technical data and manufacturing rights. Furthermore, SunPac sought to have exempt from Singapore duties any spare parts returned from petitioner to SunPac to be sold to Singaporean airlines during the time SunPac acted as a subcontractor to the advanced technology group.

SunPac’s pioneer application stated that “no royalty fees are contemplated at the present time” to be paid to petitioner. Furthermore, according to the application, SunPac intended—

at the outset to act as a subcontractor to [petitioner’s] Advanced Technology Group for the proposed aerospace product parts. It is, however, [petitioner’s] long range goal to establish the capability to distribute and sell such parts directly from Singapore. One key factor essential to the establishment of this capability are [sic] [petitioner’s] planned efforts to achieve FAA approval of its Singapore aerospace product parts manufacturing activities.

SunPac requested that the Government of Singapore (1) share in the cost of training Singaporean nationals in the United States; (2) assist in finding qualified nationals for training in the United States and participate in agreements with those trainees wherein the trainees agreed to continue their employment with SunPac for a reasonable number of years; and (3) share reasonably in the cost of training Singaporean nationals at SunPac’s facility.

In the cover letter to the EDB, petitioner represented that SunPac anticipated it would continue to manufacture also for many years to come the pneumatic sander parts, belt grinder parts, and pole pieces for which it had earlier been granted a pioneer certificate.

In the application for pioneer status, petitioner proposed the following timetable for planning, construction, and production:

(a) Date of acquisition of site: 4th quarter 1974.

(b) Date of order of machinery: start 4th quarter 1974.

(c) Date of complete arrival of all machinery: 1st quarter 1977.

(d) Commencement date of building construction: 1st quarter 1975.

(e) Completion date of building construction: 3rd quarter 1976.

(f) Commencement date of machinery installation: 3rd quarter 1976.

(g) Completion date of machinery installation: 1st quarter 1977.

(h) Commencement date of trial production: 2nd quarter 1977.

(i) Commencement date of initial production (in marketable quantities): January 1, 1978.

(j) Commencement date of full production: 3rd quarter 1978.

Petitioner represented in its application for pioneer status that its annual output in the United States over the last 3 years of the aerospace spare parts it proposed to produce in Singapore in the future was as follows:

Year Sales value

1971. S$7.8 million

1972. 9.0 million

1973. 10.9 million

Petitioner further represented that its total spare parts market projections for 1974 through 1977 (primarily satisfied by its U.S. facilities since marketable parts quantity production at SunPac was not expected until 1978) were as follows:

Year Market

1974. S$13.1 million

1975. 15.0 million

1976. 17.3 million

1977 .-. 19.1 million

Petitioner also represented that its forecasted annual output of the proposed product parts for 1978 through 1982 was as follows:

Year Sales value

1978. S$22.3 million

1979. 25.5 million

1980. 28.3 million

1981. 31.4 million

1982. 34.9 million

SunPac forecasted a 39.5-percent gross profit margin for the sales of its products. 19

On September 19, 1974, the EDB advised SunPac that the minister for finance had agreed, in principle, to grant SunPac both a pioneer certificate and an export enterprise certificate for the manufacture of aviation products and related components, and industrial machines and equipment, related products, and components. The pioneer certificate and export enterprise certificate required SunPac to commence production of commercial aviation spare parts no later that July 1, 1977, and to invest at least S$10 million in fixed assets by June 30, 1979.

The minister for finance issued to SunPac pioneer certificate No. 494 on January 5, 1978. Pursuant to this pioneer certificate, SunPac received pioneer status for a 5-year period plus export enterprise status for an additional 3-year period. On January 5, 1978, the minister for finance also issued to SunPac export enterprise certificate No. 73, which extended SunPac’s export enterprise status for an additional 7 years if SunPac invested at least S$45 million in fixed assets by the end of the pioneer status period and implemented the phase II expansion project which petitioner had proposed to the EDB by letter dated July 11, 1975.

The record is not clear as to what extent the Government of Singapore granted the additional relief SunPac sought in its applications for tax relief.

VI. PARTS MANUFACTURER APPROVAL

A. In General

The manufacture of aircraft is subject to governmental regulation in the United States and foreign countries. In the United States, the FAA controls the production of aircraft through its certification programs.

Before an airplane is built, the FAA reviews the aircraft design (including components such as engine, CSD, and generator), the engineering test data, and analyses. The FAA then issues an FAA type certificate of approval to the airframe manufacturer if the type design configurations meet a particular type design and are found to be airworthy.

Next, the aircraft is produced under the airframe manufacturer’s quality control system. The FAA then issues a production certificate. Every airplane coming off the assembly line also is issued an airworthiness certificate certifying that the aircraft meets its type design and is in condition for safe operation.

The aircraft certification process and its associated costs are strictly the responsibility of the airframe manufacturer. While manufacturers of the aircraft’s components are not directly involved, during the certification process component manufacturers such as petitioner provide engineering assistance and data to the airframe manufacturer if requested.

Upon completion of the aircraft certification process, the aircraft’s component manufacturers may apply for parts manufacturer approval (hereinafter sometimes referred to as PMA) from the FAA. A PMA holder has the right to build an FAA-approved part. To receive a PMA, the parts manufacturer must establish that its facility and quality procedures are adequate to allow the manufacturer to produce consistently parts which conform to the part’s engineering drawings and specifications which are approved as part of the airframe manufacturer’s airworthiness certificate. A separate PMA is issued for each facility at which the manufacturer produces parts. PMA certification is not limited to the original manufacturer of the part.

Some foreign countries also have a PMA-type procedure. The United States recognizes the PMA procedures of some foreign countries through reciprocity agreements with the FAA. In the mid-1970s, no reciprocity agreement existed between the United States and Singapore.

The FAA requires U.S. airlines to buy only PMA parts. Most foreign airlines also require FAA-PMA, or its equivalent, on the parts they buy.

B. SunPac’s Application for PMA

The FAA does not normally issue an FAA-PMA certificate to a facility located outside of the United States because of the surveillance and audit requirements needed to maintain certification. Nonetheless, on January 19, 1976, petitioner requested that the FAA expand petitioner’s PMA approval to include the SunPac facility. At that time, petitioner’s Denver and Rockford facilities each had separate PMA certification.

Additionally, in a letter dated April 30, 1976, petitioner asked the FAA to establish a “reimbursable agreement” between the U.S. Government and the Government of Singapore providing for FAA participation towards PMA approval and quality assurance system acceptance for the parts to be manufactured at the SunPac facility. In explaining the reasons for petitioner’s decision to manufacture commercial spare parts in Singapore, the letter explained, in part, as follows:

Reasons for this decision in 1974 were varied and were influenced most significantly by Advanced Technology managements’ [sic] long term look at a) evolving market conditions for spare part requirements for the [petitioner] products used on the world’s civil air transports and b) the significant possibilities for added product sales potentials with the emerging market and industries in this part of the world.

With respect to the civil air transport spare parts, approximately 50% of these parts are marketed outside of the U.S. with this percentage increasing annually. Many of these spare parts are for out-of-production aircraft components making it increasingly more difficult to support same in a larger component oriented manufacturing environment. Many of the older civil aircraft are in airline operations in the Far East and South Pacific and it was believed this trend might well continue.

The experiment with the Machine Tool product was generally successful in that [petitioner] learned that limited quantity production such as will be increasingly required for many aircraft component spare parts appears reasonably achievable in Singapore with a factory designed for same, a trainable work force and a stable government enjoying very good relations with the U.S. Government. It also appeared that such market conditions and projections could be satisfied without dislocation of present operations, i.e. [petitioner] U.S. operations expected and planned growth in the aerospace product field would over the future years be significantly greater than any allocation of work to [SunPac],

The letter further described the planned use of SunPac parts as follows:

The parts to be produced by [SunPac] in Singapore are primarily for spare part requirements of airlines around the world using aircraft equipped with [petitioner] components * * * The primary aircraft component for which these parts are for is the [petitioner CSD]. While the purpose of [SunPac] parts manufacture is to satisfy the aforementioned airline spare part market requirements, Sundstrand Operations may also, from time to time, use some of the parts in its repair and/or manufacture of [petitioner] aircraft components.

Additionally, in this letter and in other communications with the FAA, petitioner described the operations of SunPac as follows: (1) Key management positions in Singapore would be staffed with people from petitioner’s Rockford and Denver facilities with long experience in similar jobs; (2) all engineering drawings would be controlled by petitioner in Rockford; (3) all detailed manufacturing and inspection planning would be done by petitioner; (4) the quality assurance program would be the same program as applied in petitioner’s Rockford and Denver plants; (5) all raw materials which go into the finished products would be purchased and certified in Rockford or Denver; (6) only parts which are fully qualified and for which the manufacturing and inspection techniques have been completely proven would be produced in Singapore; and (7) SunPac would only do minor assembly work.

The FAA conducted an on-site audit of SunPac’s facility and . quality procedures to determine whether SunPac met the FAA’s standards for PMA certification. On June 15, 1977, the FAA advised petitioner that it would issue a PMA to SunPac and that the following five limitations would be attached to SunPac’s PMA:

(1) PMA letter would be issued with a 5-year limitation, at which time a reevaluation by petitioner and FAA would take place;

(2) SunPac quality manual would be required as controlling document;

(3) all raw materials, manufacturing processes, and special product-oriented service must be furnished by petitioner Denver/Rockford (any deviation must be approved by Pacific FAA region);

(4) designated manufacturing inspection representatives (DMlR’s) would not be issued until joint financial reimbursement agreement was available; and

(5) a copy of all engineering drawings referenced in the PMA letter for end items and a complete parts list breakdown of the parts to be manufactured in Singapore must be forwarded to the Pacific Honolulu FAA office.

On July 1, 1977, the FAA issued to SunPac a letter (the original PMA letter) advising SunPac that the FAA granted to SunPac parts manufacturer approved to produce the parts listed in a supplement enclosed with the letter. The original PMA letter incorporated four of the five FAA proposed limitations cited on June 15, 1977. (The original PMA letter did not request a complete parts list breakdown of SunPac’s parts.) However, on November 22, 1977, the FAA reissued the PMA certification letter (the revised PMA letter) to clarify that SunPac’s PMA was limited to the manufacture of replacement piece parts only.

During 1977 and 1978, SunPac manufactured parts for which it had not received PMA approval.

VII. THE TECHNICAL ASSISTANCE AND LICENSE AGREEMENT

A. The SunPac License Agreement

On July 15, 1975, petitioner and SunPac entered into a technical assistance and license agreement (hereinafter referred to as the SunPác license agreement). Under article II of,the SunPac license agreement, petitioner gave SunPac (1) the exclusive right and license to use petitioner’s industrial property rights 20 for the manufacture of products in Singapore; (2) the nonexclusive right and license to sell the products in any country of the world; (3) the nonexclusive right to use the products, including the right for SunPac’s customers to use the products in any country of the world; (4) the right for SunPac to subcontract in Singapore to third parties the partial manufacture of the products; and (5) the authorization for SunPac’s use in its sale of the products the trademarks of petitioner which petitioner normally used in the sale of similar products.

Under article III of the SunPac license agreement, petitioner agreed to furnish copies of existing industrial property rights as used by petitioner in the manufacture of products and reasonable technical assistance for the startup of SunPac’s manufacture of the products. The products referred to in the SunPac license agreement were certain parts to the CSD specifically set forth in exhibit A of the SunPac license agreement.

Under article V of the SunPac license agreement, SunPac agreed to pay to petitioner a royalty fee in consideration of petitioner’s industrial property rights made available and licensed to SunPac and in consideration of all assistance rendered to SunPac. The royalty fee as set forth in the SunPac license agreement was 2 percent of the net selling price of each product manufactured and sold by SunPac. The SunPac license agreement defined the net selling price as the invoice price of products sold by SunPac which were subject to royalty fee payments under article V, exclusive of any marketing service charges, discounts, or commissions (if given), and less any packing, freight, transportation, insur-anee costs, sales, added value or gross receipts taxes, customs duties, and other such charges levied and based upon such sale. SunPac was to pay this 2-percent royalty, fee until the cumulative total amount of royalties paid was equal to the original costs of petitioner’s development design and engineering of the industrial property rights plus the cost of all assistance rendered to SunPac by petitioner when such assistance cost was not otherwise paid to petitioner.

The SunPac license agreement stated that it was the parties’ intent that, within 8 years, the royalty payment obligations would equal the original cost of development design, engineering, and petitioner’s assistance costs. The SunPac license agreement stated further that, if it appeared that the royalty fee of 2 percent would not be sufficient within 8 years to equal the cost of development design, engineering, and assistance costs, the parties would amend the SunPac license agreement to increase the royalty fee or if necessary the term of the SunPac license agreement. Exhibit A to the SunPac license agreement set forth the products covered by the SunPac license agreement and petitioner’s original cost of development design and engineering of the industrial property rights.

The SunPac license agreement further provided that the royalty payments would be made within 180 days after the end of each calendar year and would accrue when a customer was invoiced for the products by SunPac. The royalty fee was payable to petitioner’s account in U.S. dollars. If, under the laws of Singapore and/or any tax convention with the United States, SunPac had to deduct taxes from sums or fees due petitioner under the SunPac license agreement, the deduction would be limited to the amount of taxes SunPac actually paid.

Finally, in consideration of the right to use petitioner’s trademark, SunPac agreed to pay petitioner $1,000 within 12 months after the date of the SunPac license agreement. The record does not show whether this payment was ever made.

The SunPac license agreement further provided that the assistance costs which petitioner incurred would be set forth in an amendment to the SunPac license agreement to be attached as exhibit B.

B. Amendments to the SunPac License Agreement

The parties amended the SunPac license agreement 11 times between April 14, 1976, and May 1, 1979.

1. Amendments Nos. 1 through 10

Amendment No. 1, executed April 14, 1976, deleted in its entirety the original exhibit A of the SunPac license agreement and substituted a new exhibit A to add additional parts; included the initial exhibit B reflecting total assistance costs incurred by petitioner through December 31, 1975, of $729,266; and amended the payment terms. As amended, the payment terms provided further that if at the end of any of the 8 years, the applicable cost of development design, engineering, and assistance costs had not been totally liquidated by royalty fee obligations, SunPac would pay petitioner the full unliquidated balance of such costs at the time the royalty fee payments were next due. The substituted exhibit A depicted original development design and engineering costs of $78,776.42.

Amendments Nos. 2 through 9 substituted new exhibits A or B to the SunPac license agreement. Amendment No. 10, executed November 22, 1978, substituted exhibit B and depicted total technical assistance costs for 1976 and 1977 of $1,216,582 and $1,298,701, respectively.

2. Amendment No. 11

When petitioner entered into the SunPac license agreement in 1975, it anticipated that all of the technical assistance costs would be recovered fully by way of the royalty payments. Thus, petitioner did not intend to charge SunPac separately for technical assistance outside of the SunPac license agreement. Petitioner provided a great deal of training and technical assistance to SunPac because SunPac was an entirely new startup operation. The parties, therefore, executed amendment No. 11 to the SunPac license agreement to provide additional compensation to petitioner for the technical assistance it rendered to SunPac for all sales on or after July 1, 1977.

Amendment No. 11, executed on May 1, 1979, amended the royalty provisions to provide as follows:

5-A. In consideration of [petitioner’s] Industrial Property Rights made available and licensed hereunder and to provide [petitioner] a reasonable profit for any assistance rendered to [SunPac] in conjunction herewith, [SunPac] agrees to pay to [petitioner], subject to the provisions of paragraphs 5-A(l) and 5-A(2) below, a royalty fee of two percent (2%) of the net selling price of each Product manufactured and sold by [SunPac] during the terms of this Agreement.

5-A(l) The parties agree that in order to assure the [petitioner] of a reasonable minimum royalty return hereunder that such royalty payments to [petitioner] shall in total amount to no less than the original cost to [petitioner] for the development design and engineering of said Industrial Property Rights for each Product. [Petitioner] has agreed to provide its best estimate of such original cost to [petitioner] for the development design and engineering for each Product at the time each such Product is included under this Agreement (it being recognized by the parties that such cost is not a current cost to [petitioner]). All such Products and said original cost of development design and engineering therefor are to be set forth in Exhibit “A” attached hereto.

5-A(2) Further, in establishing the foregoing royalty fee rate of two percent (2%) and the requirements of paragraph 5-(A)(l) it is intended that the royalty payment obligations of [SunPac] to [petitioner] under this Agreement shall be equal to or greater than such original cost of development design and engineering in no more than eight (8) years from the date of establishment hereunder of any original cost of development design and engineering (i.e. the setting forth of same in said Exhibit “A”). If at any time it appears that such royalty obligations shall not within any said eight (8) year period be as great as such applicable original cost of development design and engineering, the parties agree that they shall promptly enter into an Amendment to this Agreement whereunder said royalty fee rate shall be increased in such a manner so as to assure that said intent is achieved. In any event if at the end of any of said eight (8) year period royalty fee obligations hereunder are not equal to or greater than the applicable cost of development design and engineering [SunPac] shall pay [petitioner] a sum equal to the full difference between said royalty obligations and costs, at the time royalty fee payments are, or would otherwise be, next due under the Agreement. Such payments will be subject to the provisions of paragraphs 5-F, 5-G and 5-H.

In provision 5-B, SunPac agreed to pay petitioner for any assistance rendered to SunPac outside of Singapore. This assistance was defined as offshore assistance. Section 5-B(2) states as follows:

To facilitate payment of all such Offshore assistance costs to [petitioner] [SunPac] agrees, commencing with Products sold by [SunPac] from 1 July 1977 and thereafter, to pay to [petitioner] a fee of one and one-tenth percent (1.1%) of the net selling price of each Product sold by [SunPac], said payments to continue only until the total of all such Offshore assistance costs have been paid to [petitioner].

Section 5-B(2)(i) provides that the 1.1-percent assistance rate was intended to pay petitioner the cost of the technical assistance within 8 years and further provided that, should it appear that this goal would not be reached, the percentage rate could be increased and further that, if the cost of the technical assistance was not paid off within the 8-year period, SunPac would pay petitioner the full unliquidated balance at the time offshore assistance fee payments were or otherwise would be next due under the SunPac license agreement.

In section 5-C SunPac agreed to pay petitioner also for the cost of assistance rendered to SunPac in Singapore. Assistance in Singapore was defined as onshore assistance. SunPac agreed to pay petitioner from July 1, 1977, and thereafter 1.9 percent of the net selling price of each product sold by SunPac until the total of onshore assistance cost had been paid.

Section 5-C(2)(i) states that it was the intent of the parties that the 1.9 percent would pay the cost of the onshore technical assistance within 8 years and that, if it appeared that this 8-year goal was not going to be achieved, the rate could be increased to achieve that goal and that, at the end of 8 years, if the onshore assistance cost had not been totally liquidated by this 1.9 percent, then SunPac would pay petitioner the full unliquidated balance of the unpaid onshore assistance cost at the time onshore assistance fee payments were or would otherwise be next due under the SunPac license agreement.

Section 5-D provides for amendments to the SunPac license agreement to insure that the obligations for payment of fees would be met. Section 5-E provides that SunPac would pay petitioner a lump-sum payment of $1,000 within 12 months after the date of the SunPac license agreement for the right to use petitioner’s trademarks. Sections 5-F and 5-G restate the payment terms and tax withholding provisions contained in the SunPac license agreement as originally executed.

Section 4 of this amendment No. 11 provides as follows:

Notwithstanding the provisions of páragraphs 5-F and 5-H set forth above in this Amendment, Offshore assistance fee and Onshore assistance fee obligations under the Agreement relative to Product sales made by [SunPac] from 1 July 1977 through 31 December 1978 shall all be considered as accruing in the calendar year 1978 and initial payments relative to same may be made no later than 1 October 1979, so as to not place [SunPac] in apparent payment and reporting default hereunder.

C. Payments Under the SunPac License Agreement

Pursuant to article V of the SunPac license agreement, SunPac paid to petitioner the following amounts for 1977 and 1978: 21

Sales

Month 1977 1978

January $475,674.21 $426,482.01

February 488.633.71 1,597,720.08

March 392,015.05 1,538,114.74

April 463,509.00 1,117,570.77

May 474,836.29 1,554,429.65

June 588,061.01 1,985,560.32

July 615,417.36 1,589,510.88

August 1,027,026.53 1,803,369.90

September 545.428.71 2,011,348.06

October 596.786.10 2,088,747.01

November 324.825.11 2,057,262.39

December 619,732.07 909,048.27

Total 6,611,945.15 18,679,164.08

Royalty at 2% 132,238.90 373,583.00

Exhibit B to amendment No. 11 sets forth the offshore assistance cost from December 31, 1975, through January 1, 1978, and onshore assistance cost for the same period as follows:

Period Offshore Onshore

1/1/75-12/31/75 $408,628 $320,628

1/1/76-12/31/76 622,715 593,867

1/1/77-6/30/77 203,696 452,171

7/1/77-12/31/77 186,394 456,440

1/1/78-12/31/78 321,119 1,014,455

SunPac did not pay any technical assistance fees to petitioner under the 3-percent provision set forth in amendment No. 11 during 1977 and 1978. By a credit note dated November 1, 1979, SunPac informed petitioner that SunPac had credited petitioner for the 3-percent technical assistance fee as follows:

Sales 7/1/77 through 11/30/77. $3,109,483.81

Sales 12/1/77 through 12/31/78. 19,298,896.15

Total. 22,408,379.96

Times^3% equals. 672,251.40

D. Operations Under the Sunpac License Agreement

SunPac receives from petitioner a separate technical package for each licensed part. The technical package contains an engineering blueprint showing the finished part’s design and other specifications. The technical package also contains a set of job instruction sheets describing each manufacturing and inspection operation. If petitioner makes a design engineering change to a licensed part, petitioner sends SunPac a copy of the revised engineering print. If this causes SunPac to rework the part, SunPac bears the cost of rework.

Petitioner provided technical assistance to SunPac by, among other things, training SunPac’s personnel at petitioner’s facilities in the United States and by providing manufacturing engineering assistance in resolving manufacturing problems. Technical assistance items which petitioner considers reimbursable under the SunPac license agreement include the following: costs of petitioner’s manufacturing engineering department to conduct SunPac’s training program, costs associated with training Singaporean nationals in the United States, costs of U.S. trainers in Singapore, travel and salary expenses for manufacturing operation personnel for trips to Singapore, telephone and telex communications expenses, plant engineering support, U.S. coordinator expenses, charges for processing and related functions, miscellaneous costs such as “fair share” support of Singapore American School and Denver purchasing activity, and costs generated by the contract data manager as required for updating of license.

Petitioner rendered technical assistance to SunPac in 1977 and 1978 in the following amounts:

Technical assistance item 1977 1978

U.S. trainer in Singapore 22 $999,275 $865,217

Operational support personnel 78,656 25,839

Telephone and telex expense 75,442 145,240

Plant engineering support 17,050

U.S. coordinator 27,940 81,260

Processing 186,822 171,550

Miscellaneous 4,180 ---

Total 1,389,365 1,289,106

Petitioner also incurred $36,604 23 in administrative assistance costs (costs not contained in SunPac manufacturing costs) in 1977 which were not reimbursable under the SunPac license agreement. Petitioner incurred $46,468 in administrative assistance costs in 1978.

Petitioner has a standard provision in its license agreements which gives it the right to charge its licensees for costs it incurs incident to the assistance rendered to the licensees by petitioner’s technical representatives. It was not petitioner’s practice, however, to charge its unrelated licensees separately for technical assistance.

VIII. THE DISTRIBUTOR AGREEMENT

A. Terms of the Distributor Agreement

On April 14, 1976, petitioner and SunPac entered into an agreement (hereinafter referred to as the distributor agreement) appointing petitioner as a nonexclusive worldwide distributor for any parts manufactured for sale by SunPac for use in or in support of air vehicle applications (hereinafter referred to as SunPac parts). Pursuant to the distributor agreement, SunPac agreed to sell SunPac parts to petitioner at the price set forth for each part in attachment A to the distributor agreement. Attachment A lists by part number and name each SunPac part and its price. The prices listed in attachment A of the distributor agreement equaled 85 percent of the prices shown in petitioner’s current spare parts price list. Petitioner did not specify in the distributor agreement that the transfer price would be catalog price less a 15-percent discount to permit revisions, up or down, in the pricing should its experience under the agreement show that an adjustment in price was warranted.

The distributor agreement further provides that attachment A shall be revised from time to time to reflect part number changes and additions, and/or changes in prices. The distributor agreement was amended 11 times up through 1978 to update the parts and prices in attachment

A.

The distributor agreement places no obligation on petitioner as to the use, resale, or other disposition of SunPac parts. Petitioner pays SunPac the catalog price less a 15-percent discount on all purchases regardless of whether petitioner sells the parts to others or uses them itself. Petitioner and SunPac intended to operate under the distributor agreement only until SunPac’s direct distribution system could be implemented.

The distributor agreement contains no express provision specifying when payments from petitioner for the SunPac parts it purchases are payable. SunPac gave petitioner 6 months to pay for the SunPac parts it purchased. Petitioner took full advantage of the 6-month-payable terms and at times took even longer to pay SunPac for the SunPac parts.

In February 1977, petitioner examined its costs to distribute parts as spare parts only. Petitioner concluded then that there was no need to change its pricing system for SunPac parts.

B. Relationship to U.S. Customs Valuation

In early 1976 petitioner approached the U.S. Customs Service (hereinafter sometimes referred to as U.S. Customs) to attempt to reach a consensus as to the valuation for Customs purposes of parts imported from Singapore. Two valuation methods which could be used for this purpose are (1) the “U.S. value” method, which uses the price at which the imported product sells on the open U.S. market less appropriate cost and profit adjustments or (2) the “constructed value” method, which uses the foreign manufacturer’s actual production costs increased by an appropriate profit markup.

Petitioner proposed that:

(1) The “U.S. value” method be used to establish the dutiable value of SunPac’s parts for U.S. Customs purposes.

(2) The dutiable value would be equal to petitioner’s catalog price for the SunPac parts less a 15-percent discount.

(3) SunPac would reimburse petitioner for certain assistance costs pursuant to the SunPac license agreement.

Petitioner represented to U.S. Customs in a letter dated March 19, 1976, that petitioner estimated sales to petitioner of parts to be manufactured by SunPac (considering inflation, net 15-percent discount) to be as follows:

Year Estimated sales

1976. $1,600,000

1977. 4,700,000

1978. 10,200,000

1979. 13,600,000

1980. 17,000,000

1981 . 21,000,000

1982. 26,000,000

1983. 29,000,000

1984. 32,000,000

1985. 36,000,000

1986. 38,000,000

1987 . 41,000,000

Petitioner further represented to U.S. Customs that petitioner estimated royalty income from and assistance costs to SunPac as follows:

Royalty Year income 1 Technical Original cost Cost of Admin. assist./ design devel. modifying assist, gen. value & engineering processing costs 1

1975 2 $639,033 2 $78,777 2 $90,233 .079207

1976 $.03 715,000 70,000 117,000 .09

1977 .09 352,000 70,000 117,000 .02

1978 .20 127,000 70,000 117,000 .02

1979 .27 30,000 30,000 .02

1980 .34 35,000 35,000 .02

1981 .42 40,000 40,000 .02

1982 .50 45,000 45,000 .02

1983 .58 50,000 50,000 .02

1984 .64 55,000 55,000 .02

Royalty Year income 1 Technical Original cost Cost of Admin. assist./ design devel. modifying assist, gen. value ' & engineering ' processing costs 1

1985 .70 60,000 60,000 .02

1986 .76 65,000 65,000 .02

1987 .82 70,000 70,000 .02

In addition, petitioner represented to U.S. Customs direct and indirect experience with other distributors of aircraft/aircraft engine component parts as follows:

Direct U.S. Experience

Standard Aircraft — 20% off catalog.

Have inventory stocking.

Customers were mainly:

—airlines,

—engine repair stations.

Paid transportation.'

Advised 20% was minimum difference they could agree to for a profitable operation. For other manufacturers indicated up to 50% off catalog is practice.

Indirect U.S. Experience

Industrial Procurement Services who handles support of French Falcon Aircraft in Ú.S. obtain 20+% off catalog for aircraft parts they procure from France for distribution in U.S.

Have some inventory.

Customers:

—aircraft users, .

—aircraft repair stations.

Handle field service and warranty administration.

Assume they pay duty and transportation from France.

Allison distributors buy from Allison at 40% off parts catalog.

Have inventory.

Pay U.S. transportation.

Customers:

—engine operators,

—engine repair stations.

Handle all field service and warranty administration.

Beech, Lear and Cessna similarly sell to distributor network at 20+% off.

Cooper, Van Dussen, Anglo American and others have wanted to be our distributor. Minimum amount off catalog was always 20%.

Direct Foreign Experience

Avio Diepen, Netherlands — 20% off catalog.

Inventory some.

Transportation generally paid by Avio.

Customers:

—Fokker,

—airlines,

—engine manufacturers,

—foreign government agencies.

Hawker De Havilland, Australia — 20% off catalog.

Inventory some.

Transportation generally paid by Hawker.

Customers:

—own engine repair for customers,

—charge catalog for parts used,

—engine operators,

—foreign government agencies.

Nissho-Iwai Ltd., Japan — 10% off catalog.

Sales representative only, no inventory.

Transportation to Japan & duty if any paid by their customers Customer:

—Japanese government agencies,

—engine component repair stations,

—aircraft/engine component licensed manufacturers.

In support of the transfer price for U.S. Customs purposes, petitioner justified the 15-percent difference between the catalog price (the U.S. sales price) and the distributor agreement purchase price as follows:

Estimated Breakdown of 15-Percent Difference Between Catalog and Distributor Purchase Price (Averaged Over All Imports)

Percent of catalog prices

Distributor costs: Transportation costs 1.0%

Duty 1.0 to 5.0

General & administrative:

Brokerage costs 0.5%

Administrative costs 2.0

Interest, taxes, storage, etc. 5.0 7.5

Total 9.5 to 13.5

Distributor profit range based on cost estimate 5.5 to 1.5

Based on petitioner’s representations to it, the U.S. Customs Service agreed to accept the “U.S. value” method for valuation of dutiable SunPac parts. The U.S. Customs Service, however, concluded that, due to certain administrative assistance costs not reimbursed to petitioner or carried as a cost to SunPac, the proper U.S. value was 86 percent of the catalog price rather than the 85 percent proposed by petitioner.

Since the inception of SunPac’s CSD operations, for U.S. Customs purposes petitioner consistently has imported SunPac CSD parts at a price equal to 86 percent of the catalog price.

C. Market for SunPac Parts

In October 1975, petitioner performed a distribution study for SunPac-designated parts (hereinafter referred to as the distribution study). The distribution study used 1,104 spare parts considered for SunPac manufacture and reflected the market for these spare parts as follows:

Percent of sales

Estimated

Location of airline customer 1974 1979

United States 66% 51%

Cemada and South America 8 11

Europe, Africa, and the Middle East 21 32

Far East 5 6

1974 sales of SunPac-designated parts by distribution area used in the distribution study were as follows:

Area Sales

United States, Canada, and South America. $5,940,895.84

Europe, Africa, and the Middle East. 1,659,341.29

Far East. 426,008.80

Total. 8,026,245.93

This distribution study Usted petitioner’s ten largest airhne spare parts customers based on 1974 sales as follows: United AirUnes, Trans World AirUnes, Delta AirUnes, Pan American, the Societe Anonyme Beige d’Exploitation de la Navigation Aerienne (Sabena Belgian World AirUnes) (hereinafter referred to as SABENA), American AirUnes, Western AirUnes, Japan AirUnes, Eastern AirUnes, and Air Canada.

Customers and quantity of orders expected for each category of parts as reflected in the distribution study were as foUows:

Group A Group B Group C Group D Total anticipated

Number of

customers 90 114 114 114 Estimated

number of 1,200 1,400 1,200 3,800 7,600 orders per year

D. Sales of SunPac Parts

Throughout 1977 and 1978, SunPac’s operations consisted of the manufacture of aviation spare parts, which were used for petitioner’s CSD’s and other end items. All of SunPac’s gross income for 1977 and 1978 came from the sale of SunPac parts to petitioner (other than some miscellaneous commission and interest income). All of these sales to petitioner were made under the distributor agreement at the catalog prices published in the spare parts price list, if available, less a 15-percent discount. In 1978, in addition to the sale of SunPac parts to petitioner, SunPac shipped spare parts with a spare parts price list value of $247,786 to SABENA pursuant to a consignment agreement entered into in 1978. SunPac began making sales to SABENA under the consignment agreement in 1979. See infra.

All of SunPac’s sales to petitioner were made f.o.b. Singapore. During 1977, petitioner purchased SunPac parts totaling $6,595,000. During 1978, petitioner purchased SunPac parts totaling $18,605,000.

According to the Forms 2952, Information Return with Respect to Controlled Foreign Corporations, petitioner filed relating to SunPac for its fiscal years ended November 30, 1977, and November 30, 1978, SunPac’s gross receipts and net earnings before taxes for those periods were as follows:

11/30/77 11/30/78

Gross receipts $6,142,610 $18,318,000

Net earnings 2,573,000 12,848,000

A portion of the parts purchased by petitioner from SunPac failed to meet petitioner’s specifications. Upon closer inspection, these parts were: (a) Deemed acceptable as is, (b) deemed acceptable after rework by petitioner, or (c) scrapped. Petitioner’s total rework and scrap costs with respect to these parts amounted to $347,373 for 1977 and $140,481 for 1978. During 1977 and 1978, petitioner did not charge SunPac for the rework and scrap costs of the SunPac parts.

Petitioner (a) resold SunPac parts at the catalog price to the airlines, (b) used them as spare parts in its overhaul and repair activities, (c) used them in the manufacture of subassemblies which were sold as spare parts, or (d) used them in the manufacture of OEM or spare units. Petitioner paid SunPac the catalog price less 15 percent regardless of the use to which it put the part.

The sale of commercial spare parts represented around 10 or 11 percent of petitioner’s business for 1977 and around 14 or 15 percent for 1978. Petitioner made no additional investment in physical assets to distribute SunPac parts pursuant to the distributor agreement. Between 10 to 15 percent of the time of petitioner’s commercial products support department was spent distributing SunPac parts.

Petitioner projected distribution costs as a percentage of catalog prices for 1977 of 11.8 percent and experienced actual distribution costs of 12 percent. Petitioner projected distribution costs as a percentage of catalog price for 1978 of 12.1 percent and incurred actual costs to distribute of 9.2 percent.

Petitioner incurred U.S. Customs duties with respect to SunPac parts of $237,758 and $880,585 during 1977 and 1978, respectively. Petitioner also incurred freight, insurance, and broker costs of $39,372 and $110,762 during 1977 and 1978, respectively. Petitioner’s duty, freight, and insurance costs for SunPac parts were reflected in the overhead expenses allocated to SunPac parts.

During the years in issue, petitioner and SunPac maintained “dual sourcing capabilities” for CSD parts. SunPac sold 287 different SunPac parts to petitioner during its 1977 fiscal year. SunPac sold a total of 312 different SunPac parts to petitioner during its 1978 fiscal year.

SunPac also manufactured 73 “single-sourced” parts in 1977 and 91 “single-sourced” parts in 1978.

During 1977 and 1978 SunPac shipped roughly 30 different parts to petitioner in an unfinished state. Petitioner’s cost to finish these incomplete SunPac parts, exclusive of inspection costs, totaled $29,600 and $113,604 for 1977 and 1978, respectively. Petitioner did not charge SunPac the costs incurred to finish the incomplete parts. The record does not show the fair market value of the unfinished SunPac parts immediately before and immediately after petitioner completed the manufacturing process on these parts. Petitioner concedes that at arm’s length, SunPac should be charged back petitioner’s costs incurred with respect to certain defective and unfinished parts in the amount of $631,000 for 1977 and 1978, computed as follows:

1977 1978 Total

Cost to rework parts $106,606 $56,987 $163,593

Cost of scrapped parts 240,767 83,494 324,261

Cost to finish parts 29,600 113,604 143,204

Total 376,973 254,085 631,058

Due to parts design complexity, the special processes and machinery, the manufacturing know-how, and the large manufacturing startup costs, generally petitioner could not purchase the parts manufactured by SunPac from unrelated vendors. During 1977, petitioner did not purchase from outside sources any of the parts produced by SunPac. During 1978, petitioner purchased from outside sources eight of the parts produced by SunPac. Petitioner’s total purchases of these eight parts amounted to $3,400. SunPac’s total revenue from sales to petitioner for these same eight parts in 1978 was $54,154. The record does not show the quantity of these eight parts purchased from the third-party manufacturers or the quantity of these eight parts manufactured by SunPac.

During 1977 and 1978, SunPac was at the low end of the learning curve for CSD production. Therefore, it probably was the least efficient plant then producing CSD parts.

IX. LUCAS TRANSACTIONS

Since the early 1950s, petitioner has entered into various agreements with Lucas Industries, Inc. (hereinafter referred to as Lucas), and/or its predecessors in interest regarding petitioner’s CSD’s. 24 Lucas is a public corporation, unrelated to petitioner, traded on the London Stock Exchange.

A. License Agreements

1. The 1953 General License

On November 27, 1953, petitioner and Lucas entered into a CSD license agreement (hereinafter referred to as the 1953 general license). The 1953 general license, among other things, granted Lucas (a) the exclusive right to manufacture CSD units and spare parts in the United Kingdom for both commercial and military applications; (b) the exclusive right to sell such CSD’s and spare parts in the United Kingdom subject to petitioner’s reservation of the right at all times to use and sell in the United Kingdom CSD’s manufactured by petitioner in the United States; and (c) the nonexclusive right to use and sell throughout the British Commonwealth CSD’s made in the United Kingdom for aircraft and guided missile use, together with the nonexclusive right to sell CSD’s, components, and spare parts made in the United Kingdom in all countries of the world where they are shipped from the United Kingdom as part of a complete aircraft engine-drive-alternator assembly made in the United Kingdom or as part of a complete aircraft or a complete guided missile made in the United Kingdom.

The agreement also granted Lucas the right to use the Sundstrand trademark and further required Lucas to place the Sundstrand trademark on each CSD and transmission it manufactured, except where prohibited by the British Government.

The 1953 general license further provided Lucas complete access to all of petitioner’s know-how, including design and development rights for all CSD’s under production, and to any improvements, changes, and modifications made' to those CSD’s. Moreover, petitioner agreed, to furnish technical assistance, at Lucas’ expense, to assist Lucas in the manufacture, assembly, inspection, testing, and servicing of the CSD’s. Lucas also, at its own expense, could send a technical representative to petitioner’s Rockford, Illinois, facility to observe and study petitioner’s methods in the manufacture, assembly, inspection, testing, and servicing of CSD’s. '

The 1953 general license provided for payments as minimum royalties of $37,500 each bn January 10, 1954, and March 10, 1954. In addition, the 1953 general license required royalty payments to petitioner on sales as follows:

(1) 6 percent on total net selling price up to and including 2,780,000 pounds;

(2) 3-1/2 percent on total net selling price in excess of 2,780,000 pounds and up to 6,560,000 pounds;

(3) 2 percent on total net selling price in excess of 5,560,000 pounds; with

(4) 1/6 of the royalties to be rebated until the rebate equals $75,000.

The 1953 general license also provided that if petitioner sold CSD’s in the United Kingdom other than through Lucas, petitioner must pay Lucas a commission of 5 percent on the net selling price of the CSD’s.

Lucas agreed to be responsible for any claims, except patent infringement claims of third parties, arising from the sale or use of the CSD’s it manufactured and to indemnify and hold petitioner harmless from all liability for any claims arising from the manufacture, sede, or use of CSD’s made by Lucas.

In addition, Lucas agreed to inform petitioner of any inventions, improvements, or modifications in petitioner’s CSD’s made by Lucas’ employees. Moreover, Lucas gave petitioner a free, exclusive license in the United States and a nonexclusive license elsewhere in the world to use any of those inventions, improvements, and modifications.

The 1953 general license was for a term of 15 years and would extend automatically for 1 or more 5-year periods unless terminated by written notice given 2 years before the expiration daté.

2. Amendments to the 1953 General License

a. The 1960 amendment.

By amendment executed November 3, 1960, petitioner gave Lucas, among other things, the nonexclusive right to sell CSD’s made in the United Kingdom in Belgium, France, Holland, Italy, Luxembourg, Portugal, Spain, and West Germany (hereinafter referred to as the listed countries), but only where the CSD’s were shipped as part of a complete drive-alternator assembly, including associated electrical equipment designed by petitioner; and the nonexclusive right to sell in the Usted countries spare parts for CSD’s and associated electrical equipment but only to purchasers of those drive-alternator assembUes and then only for use by the purchasers as spare parts for the drive-alternator assem-bUes. The royalty fee for these sales was 10 percent of the net selling price and was not subject to the one-sixth rebate.

b. The 1962 amendment.

By amendment executed June 30, 1962, petitioner gave Lucas, among other things, the nonexclusive right and Ucense to seU CSD’s manufactured by Lucas in the United Kingdom, and spare and replacement parts for these CSD’s, to Svenska Aeroplan Aktiebolaget (SAAB) and/or to the Royal Swedish Air Board for use only on a new fighter aircraft projected to be manufactured in Sweden. The royalty fee for these sales was 10 percent of the net selling price. This royalty also was not subject to the one-sixth rebate.

c. The 1964 amendment.

By amendment executed sometime in 1964 (hereinafter referred to as the 1964 amendment), petitioner gave Lucas and its subUcensees, among other things, the exclusive right to sell in the United Kingdom and the nonexclusive right to seU in France, CSD’s manufactured whoUy in the United Kingdom or partly in the United Kingdom and partly in France for use on or in connection with the Concorde (a supersonic transport then being proposed for manufacture by a joint arrangement between the Governments of Great Britain and France), 25 and the nonexclusive right to use and sell throughout the world the Concorde CSD’s.

The 1964 amendment also gave Lucas the nonexclusive right to sell throughout the world spare and replacement CSD’s and spare parts for use on the Concorde as long as the Concorde remained in regular commercial service. The 1964 amendment further gave Lucas the right to have manufactured in France CSD’s for the Concorde under a sublicense to Auxilec, a French company.

Exhibit B to the 1964 amendment is an agreement dated July 28, 1964, among petitioner, Lucas, and Auxilec (hereinafter referred to as the Tripartite agreement). The Tripartite agreement relates to the Concorde aircraft. In the Tripartite agreement Auxilec agreed, among other things, to sell CSD’s for the Concorde only to Lucas or petitioner except for its right to supply spare parts of its own manufacture or of Lucas’ manufacture to French operators of the Concorde in France and to maintain or overhaul CSD’s in France for French operators of the Concorde. Auxilec agreed to. pay Lucas a royalty of 8.5 percent of the net selling price of all CSD parts (including spare parts) manufactured and/or sold by Auxilec (except the royalty would be 10 percent on sales of CSD spare parts for use in the Concorde to purchasers other than Lucas).

Further, in the Tripartite agreement, Lucas agreed to pay petitioner a royalty of 8.5 percent of the net selling price to the manufacturer or user of the Concorde aircraft of all CSD’s and spare parts manufactured and sold by Lucas and/or Auxilec (unless the royalty payable by Auxilec was 10 percent, in which case Lucas would pay petitioner a 10-percent royalty). Lucas also agreed to pay petitioner a royalty of 8.5 percent of the net selling price of all parts manufactured by Lucas of the transmission then known as the variator of the Auxivar including components and spare parts and sold by Lucas for the Concorde provided that the royalty would not be less than 1.5 percent of the net selling price to the manufacturer or user of the Concorde of the complete Auxivar and electrical generating system comprising the variator-alternator assembly. The royalty rates applicable to the Concorde CSD were in lieu of the rates otherwise specified in the 1964 amendment to the 1953 general license.

During the 1960s, the Concorde’s British manufacturer, British Aircraft Corp., projected the Concorde would be a substantial commercial program. It projected it would manufacture and sell 200 Concorde aircraft to airlines throughout the world. Each Concorde would require four CSD units.

The 1964 amendment further amended the basic royalty payment provisions to provide a royalty fee of 6 percent of the net selling price up to £2,780,000 and 3.5 percent of the net selling price over £2,780,000.

In addition, for a 2-percent royalty for 15 years (hereinafter referred to as the sunset royalty provision), the 1964 amendment gave Lucas the nonexclusive right to use worldwide all unpatented technical information supplied by petitioner following the termination by notice of the 1953 general license.

The 1964 amendment further provides that the agreement would continue until December 31, 1978, and thereafter from year to year unless terminated by not less than 5 years written notice.

3. The 1966 General License

On May 19, 1966, but effective January 1, 1966, petitioner and Lucas entered into an agreement whereby they canceled the 1953 general license and simultaneously entered into a new license (hereinafter referred to as the 1966 general license). The 1966 general license for the most part incorporated the terms and provisions of the 1953 general license, as amended, including the sunset royalty and Concorde CSD provisions. The royalty fee provisions were amended to provide royalties on the sales of CSD’s (including spare parts) of 3.5 percent of the total net selling price (hereinafter referred to as the basic royalty fee) except for sales of CSD’s or spare parts in the listed countries in which case the royalty' fee remained at 10 percent; the sales of certain reservoirs in which case the royalty fee was 6 percent; and the payment provisions in exhibit B. Exhibit B to the 1966 general license was not made a part of the record; however, from the text of the 1966 general license, it appears that exhibit B is same exhibit B which was an attachment to the 1964 amendment, that is, the Tripartite agreement between petitioner, Lucas, and Auxilec pertaining to the Concorde.

4. Amendments to the 1966 General License

a. The first 1968 amendment.

An airiendment executed January 1, 1968, rewrote a provision of the 1966 general license to give Lucas and its sublicensees a nonexclusive right to sell CSD’s and spare parts made in the United Kingdom in the listed countries but only for use on aircraft first flown 26 in those countries, or for use in guided missiles manufactured in any of those countries. The basic royalty fee was amended to 3.5 percent of the net selling price of all CSD’s (including spare parts) sold for the use of the Government of the United Kingdom and 5 percent of the total net selling price of CSD’s (including spare parts) sold to most purchasers other than for use of the Government of the United Kingdom. In addition, the royalty fee for CSD’s and spare parts sold in the listed countries was decreased to 6.5 percent of the net selling price.

b. The TU-144 amendments.

The 1966 general license was further amended on January 1, 1968, and May 31, 1968, to authorize Lucas to sell a specified number of CSD’s to Aviaexport, an agency of the Soviet Union, for use on the Soviet TU-144 commercial aircraft. The royalty fees for these sales were (1) the greater of (i) 10 percent of Lucas’ net selling price to Aviaexport of all transmissions and CSD’s and spare parts for them, and 10 percent of all payments made by Aviaexport for engineering fees, qualification testing, prototype testing, prototypes, and other similar matters or (ii) 6 percent of the total contract price charged to Aviaexport for the transmissions and/or CSD’s and alternators (if any) and 6 percent of the payments made by Aviaexport for engineering fee, qualification testing, prototype testing, prototypes, tooling (including special tooling), and other similar matters, and (2) 10 percent of all spare transmissions and/or CSD’s and spare parts for them.

5. The 1970 Licenses

The 1966 general license, as amended, had to be assigned to Lucas as a result of Lucas’ acquisition of English Electric’s CSD business. See supra note 24. Petitioner took this opportunity to renegotiate its agreement with Lucas to obtain a higher royalty rate to reflect the advanced technology in CSD’s and, hence, the decreased competition from other types of CSD’s. As a result of these negotiations, in August 1970, petitioner and Lucas entered into four separate licenses: the 1970 general license, the 1970 MRCA license, the 1970 Concorde license, and the 1970 TU-144 license. These four license agreements were in effect during 1977 and 1978.

a. The 1970 general license.

The 1970 general license canceled the 1966 general license and replaced it simultaneously with a new agreement effective August 1, 1970, which basically embodied the provisions of the 1966 general license. Thus, rights granted to Lucas, among other things, include:

(1) The exclusive right to sell CSD’s in the United Kingdom for aircraft and guided missiles manufactured in the United Kingdom subject to petitioner’s right to sell in the United Kingdom CSD’s or spare parts manufactured by it in the United States (with payment of a commission of 5 percent of the net selling price); 27

(2) the nonexclusive right to sell throughout the listed countries CSD’s made in the United Kingdom for use in aircraft first flown in the listed countries and for use on guided missiles manufactured in those countries; 28

(3) the nonexclusive right to sell throughout the world, except the United States, CSD’s made in the United Kingdom for original installation in aircraft manufactured in those countries under license from a United Kingdom company to manufacture aircraft substantially identical to aircraft designed and manufactured in the United Kingdom by that United Kingdom company;

(4) the nonexclusive right to sell throughout the world CSD’s manufactured by Lucas, where those CSD’s are to be used on military aircraft or guided missiles procured by or for the Government of the United Kingdom, provided that the military aircraft or guided missiles are to be operated by the Government of the United Kingdom;

(5) the nonexclusive right to sell throughout the world replacement CSD’s and spare parts for use as such, for CSD’s made and sold by Lucas in accordance with the agreement.

The 1970 general license fixes the royalty rate at 6.5 percent of the total net selling price on all transmissions and CSD’s and spare parts for them (with one exception, whether or not of petitioner’s design) for contracts received after August 1, 1970, except for certain military applications for which the royalty rate remained at 3.5 percent, and at the 1966 general license rates, as amended, for contracts received before August 1, 1970. Under the 1970 general license, if Lucas proposes to sell its VSCF system, petitioner may convert Lucas’ exclusive rights under the 1970 general license to nonexclusive rights and terminate petitioner’s obligation to furnish data and services. The 1970 general license also includes the 2-percent sunset royalty provision.

b. The 1970 MRCA license.

On August 3, 1970, petitioner and Lucas entered into a license agreement involving specifically the MRCA (multi-role combat aircraft) program (hereinafter referred to as the 1970 MRCA license). See infra regarding the agreement between petitioner and Siemens Aktiengesellschaft also relating to the MRCA program.

The 1970 MRCA license encompasses the basic provisions of the 1970 general license. Under the 1970 MRCA license, among other things, petitioner gives Lucas:

(1) The exclusive right to manufacture and sell MRCA CSD’s in the United Kingdom subject to petitioner’s right to sell in the United Kingdom MRCA CSD’s and spare parts manufactured by petitioner in the United States (with payment to Lucas of a commission of 5 percent of the net selling price of those CSD’s and spare parts not sold through Lucas);

(2) the nonexclusive right to sell throughout the world MRCA CSD’s manufactured by Lucas where those MRCA CSD’s Eire to be used on MRCA aircraft procured by or for the Governments of the United Kingdom, the Federal Republic of Germany, and/or ItEily, provided the MRCA aircraft are to be operated by those Governments; 29 and

(3) the nonexclusive right to sell throughout the world, except the United States, MRCA CSD’s made in the United Kingdom for original installation in Etircraft manufactured in those countries under license from a United Kingdom, German, and/or Italian company to manufacture aircraft substEmtially identicsil to MRCA’s designed and manufactured by such company.

The 1970 MRCA license provides for a royalty of 6.5 percent of the net selling price of all MRCA CSD’s, and parts for them, sold by Lucas. The 1970 MRCA license also incorporates the 2-percent sunset royalty provision.

c. The 1970 Concorde license.

Petitioner and Lucas also entered into a new license for the Concorde program in August 1970 (hereinafter referred to as the 1970 Concorde license). The 1970 Concorde license incorporates for the most part the terms and provisions of the 1966 general license as they applied to the Concorde aircraft program. Thus, under the 1970 Concorde license petitioner gives Lucas, among other things:

(1) The exclusive right to manufacture in the United Kingdom Concorde CSD’s;

(2) the right to sublicense Auxilec to manufacture parts for Concorde CSD’s in France subject to the terms and provisions of the Tripartite agreement;

(3) the exclusive right to sell in the United Kingdom, and the nonexclusive right to sell in France, Concorde CSD’s manufactured wholly in the United Kingdom or partly in the United Kingdom and partly. in France and the nonexclusive right to use and sell throughout the world Concorde CSD’s as a part of a complete Concorde aircraft;

(4) the right to sublicense Auxilec to use and sell Concorde CSD’s and parts of them, subject to the terms and provisions of the Tripartite agreement;

(5) the nonexclusive right to sell throughout the world spare and replacement Concorde CSD’s and spare parts for them for use as such for Concorde CSD’s made and sold in accordance with the 1970 Concorde license.

Under the 1970 Concorde license, Lucas agreed to pay petitioner royalties in accordance with the royalty payment terms and provisions in the Tripartite agreement. Furthermore, petitioner agreed to pay Lucas a commission of 10 percent of the selling price of any Concorde CSD’s and/or spare parts for them petitioner sells anywhere in the world, unless at the time of the sale Lucas could not supply the CSD and/or spare parts.

d. The 1970 TU-144 license.

On August 3, 1970, petitioner and Lucas entered into a separate CSD license for the Soviet commercial supersonic aircraft, the TU-144 (hereinafter referred to as the 1970 TU-144 license). The 1970 TU-144 license gives Lucas the exclusive right to manufacture and sell in the United Kingdom TU-144 CSD’s manufactured in the United Kingdom to Aviaexport or any agency of the Soviet Union. In addition, the 1970 TU-144 license gives Lucas the nonexclusive right to sell worldwide replacement TU-144 CSD’s and spare parts for TU-144 CSD’s made and sold by Lucas.

The 1970 TU-144 license requires the same royalty as specified in the TU-144 amendments to the 1966 general license. Under the 1970 TU-144 license petitioner must pay Lucas a commission equal to 6.5 percent of the CSD units or spare parts selling price if petitioner sells anywhere in the world TU-144 CSD’s unless, at the time of the sale, Lucas could not supply the TU-144 CSD or spare parts.

6. Other Lucas Licenses

a. The 1977 traction drive license.

In the early 1960s, Lucas developed its Perbury traction CSD (hereinafter referred to as the Lucas traction drive) and successfully placed it on the British Government’s Harrier aircraft program. Petitioner was interested in obtaining a license from Lucas relating to the Lucas traction drive. On March 4, 1977, Lucas gave petitioner a license for this CSD (hereinafter referred to as the 1977 traction drive license). The 1977 traction drive license gives petitioner the exclusive right to manufacture in the United States and its possessions Lucas traction drives and spare parts for those drives; the exclusive right to sell Lucas traction drives for installation in aircraft first flown in North América; and the nonexclusive right to sell throughout the world replacement Lucas traction drives and spare parts for use as such for Lucas traction drives sold by petitioner.

In the 1977 traction drive license, the parties also agreed to undertake further research and development in the field of traction drives. According to the 1977 traction drive license:

[Petitioner] has represented to Lucas that it expects to expend each year a sum of approximately Two Hundred Thousand Dollars ($200,000.00 U.S.) on such development work, in addition to any expenditure or work it may undertake on applications engineering. Lucas has relied on this representation in agreeing to grant the rights and licenses to [petitioner] contained in this Agreement, and in establishing the level of royalties and other payments by (petitioner] provided * * * below.

In consideration for the 1977 traction drive license, petitioner agreed to pay Lucas the following:

(2) in general, a royalty fee of 6.5 percent of the toteil net selling price of all traction drives and Lucas traction drives, and spare parts for those CSD’s, sold by petitioner. However, petitioner could deduct from the net selling price two times the purchase price of any supplies purchased by petitioner from Lucas in furtherance of petitioner’s traction drive sales activity; 30

(1) $100,000, in two equal installments, the first one due within 30 days of the coming into effect of the agreement and the second installment due within 12 months after payment of the first installment;

(3) a commission fee of 6.5 percent of the total net selling price of all CSD’s, and spare parts for those CSD’s, not falling within the scope of (2) above but made and sold by petitioner for installation in the U.S. Marine Corps military aircraft AV8B, or in any aircraft which is basically a modification of the AV8B aircraft.

b. The 1977 PRC license.

On March 4, 1977, petitioner and Lucas entered into an agreement (hereinafter referred to as the 1977 PRC license) wherein petitioner gave Lucas the exclusive right to manufacture petitioner’s CSD’s in the United Kingdom for use on aircraft first flown in the People’s Republic of China other than aircraft of a design originating in the United States; the nonexclusive right to sell those CSD’s in the People’s Republic of China; and the nonexclusive right to sell replacement CSD’s and spare parts for those CSD’s throughout the world. In return, Lucas agreed to pay petitioner a royalty of 10 percent of all transmissions and CSD’s, and spare parts, sold pursuant to the 1977 PRC license together with 10 percent of all payments received by Lucas for engineering, qualification testing, prototype testing, prototypes, and other matters relating to such CSD’s and transmissions.

B. Sales Agreements

1. The 1962 Sales Agreement

In an agreement entered into on June 30, 1962 (hereinafter referred to as the 1962 sales agreement), petitioner and Lucas agreed to promote actively the sale of CSD-alternator assemblies in the listed countries and particularly CSD-alternator assemblies embodying CSD’s of a design Lucas had not manufactured before. Under the 1962 sales agreement, each party agreed to pay the other party a commission of 5 percent of the net selling price of CSD’s sold by it for use in aircraft first flown in the listed countries or guided missiles manufactured in those countries, and on all spare CSD’s and parts sales resulting from the sale of the units originally installed on the specific aircraft or guided missile. The 1962 sales agreement • did not modify or alter the 1963 general license.

2. The 1968 Sales Agreement

Petitioner and Lucas canceled the 1962 sales agreement on January 1, 1968, and entered into another agreement on that same day (hereinafter referred to as the 1968 sales agreement). In the 1968 sales agreement the parties agreed to pay each other a commission on sales of CSD’s in the listed countries for use in aircraft first flown in those countries or for use in guided missiles manufactured in those countries. The commission rate was (1) the greater of (i) 5 percent of the net selling price of CSD’s sold by it or (ii) 3.5 percent of the total contract price charged to the customer for the CSD and alternator (if any), and (2) 5 percent on all spare CSD’s and parts sold as a result of the sales of CSD’s originally installed on aircraft or guided missiles. 31 Petitioner further agreed to pay Lucas 10 percent of the selling price of any CSD and/or spare parts for use on the Concorde (unless Lucas could not supply that CSD or spare part at the time of sale) and 6.5 percent of the selling price of CSD’s and/or spare parts for use on the TU-144 (unless Lucas could not supply that CSD or spare part at the time of sale).

Lucas and petitioner agreed, however, that the 1968 sales agreement became of no force and effect as of April 1, 1969, when Rotax Ltd. purchased the business of English Electric relating to the manufacture and sale of CSD’s. See supra note 24.

C. Lucas Operations Under the Licenses

After entering into the 1953 general license, Lucas spent about $4 million to establish manufacturing, development, and test facilities for CSD’s and generators in England. Lucas required approximately 4 years to become proficient in the manufacture of CSD’s. Both during and after the startup period, Lucas required technical assistance from petitioner. Lucas transferred a number of its engineers for various periods to petitioner’s Rockford facility. Lucas also installed a liaison engineer at petitioner’s Rockford facility until 1960 and during that time a continuous stream of know-how passed from petitioner to Lucas and from Lucas to petitioner. Petitioner further sent a number of its engineers to England to assist Lucas. There was also telephone and telex communication between the parties. Petitioner did not charge Lucas for this technical assistance.

At one time Lucas considered terminating the 1970 licenses and using petitioner’s technology under the sunset royalty provisions. Lucas, however, chose to continue the 1970 general license rather than terminate it and sell CSD units and parts worldwide under the 2-percent sunset royalty provision because Lucas believed that the 1970 general license, with its continuing design and development rights for a 6.5-percent royalty, was more valuable than the right to use for a 2-percent royalty existing CSD technology to manufacture and sell CSD parts and units worldwide.

From time to time when Lucas was having production or capacity problems, Lucas purchased parts from petitioner. Lucas used the parts purchased from petitioner in its CSD OEM unit production. Lucas paid the catalog price or a catalog-equivalent price for all parts purchased from petitioner. During 1974 through 1978, Lucas purchased the following parts from petitioner at the catalog or catalog-equivalent price for use in CSD unit production:

Year Amount

1974. $53,786

1975. 104,286

1976. 248,938

1977. 258,556

1978. 497,204

X. OTHER LICENSE TRANSACTIONS

A. The Teijin License

In the mid-1960s the Japanese Defense Agency (hereinafter referred to as JDA) asked petitioner’s Japanese trading agent, Nissho Iwai (hereinafter referred to as Nissho), to ask petitioner to establish a Japanese source for CSD units and spare parts being supplied for the JDA’s military programs. Nissho suggested three Japanese companies as possible license candidates. In 1965, petitioner selected Teijin Seiki Co. Ltd. (hereinafter referred to as Teijin) as the best candidate. At all relevant times, Teijin was a public corporation unrelated to petitioner. During 1977 and 1978, Teijin employed 2,000 individuals and generated sales of $83 million.

On January 26, 1967, Teijin and petitioner entered into a license agreement (hereinafter referred to as the Teijin license). In the Teijin license petitioner gave Teijin, among other things, the exclusive right to manufacture in Japan and the nonexclusive right to sell in Japan those CSD’s and replacement CSD’s for use only on (a) aircraft built in Japan, including aircraft built there under license from its U.S. manufacturer; (b) military type aircraft owned, built, or modified by or for the Government of Japan; and (c) aircraft built outside Japan which do not use CSD’s manufactured by petitioner. In addition, petitioner gave Teijin the nonexclusive right to sell worldwide, except in the United Kingdom, replacement CSD’s to purchasers of aircraft manufactured in Japan but only for use as replacements for CSD’s made by Teijin and used as such.

In consideration for the rights, technology, and technical assistance given to Teijin under the Teijin license, Teijin agreed to pay petitioner a royalty of 6.5 percent of the net selling price of all CSD’s sold by Teijin in Japan and 10 percent of net sales outside of Japan. In addition, Teijin agreed to pay petitioner a $100,000 initial lump-sum payment for the transfer of technology and proprietary information, know-how, and data. However, Teijin could credit one-half of that sum against one-half of future royalties if at the end of the first 4 years following the effective date of the agreement petitioner was unable to establish Japanese patents covering the licensed products (until $50,000 was entirely credited or a patent was issued in Japan, whichever occurred first).

Petitioner provided technical assistance to Teijin during the 2 years following the date the parties entered into the Teijin license. Although the Teijin license gave petitioner the right to charge petitioner’s technical assistance costs to Teijin, petitioner did not charge Teijin for this assistance.

The Teijin license initially was for a 12-year term with automatic 5-year extensions absent a 1-year notice of termination. The term of the Teijin license was amended on June 9, 1967, to 10 years from the date of receipt by petitioner of the $100,000 lump-sum payment and on September 17, 1975, to extend from June 27, 1967, through June 26, 1987.

By letter memorandum dated June 13, 1967, the parties expressed their understanding that, upon termination of the Teijin license for reasons other than , default or breach by Teijin, Teijin had the right to use any of petitioner’s unpatented technology pertaining to CSD’s transferred under the Teijin license in exchange for payment for 10 years of a royalty of 3 percent of the net selling price. Teijin’s gross sales of CSD units and parts during 1977 and 1978 were $3,111,304 and $4,938,031, respectively. Royalties on these sales for 1977 and 1978 were $202,235 and $320,972, respectively. After withholding income taxes, Teijin paid to petitioner for 1977 and 1978 $182,012 and $288,875, respectively.

When Teijin entered into the Teijin license with petitioner, Teijin’s employees could perform the basic manufacturing skills necessary to manufacture CSD units and spare parts, except for the manufacture of gears. Teijin’s employees did not have the basic skills necessary to test CSD’s and spare parts.

Before commencing production under the Teijin license, Teijin made a capital investment of $3 million to upgrade and obtain the necessary machinery, tooling, and gaging to manufacture and test CSD units and spare parts.

Teijin did not perform any independent CSD research and development under the Teijin license. Teijin used the manufacturing processes and' procedures provided by petitioner under the Teijin license but did make some changes which did not affect the quality of the CSD’s. Between 1967 and 1978, Teijin did not suggest any engineering changes to petitioner’s CSD technology, nor did it provide petitioner with any inventions, improvements, or modifications to the CSD technology.

Teijin made revisions to its quality control manual to encompass the manufacture of'USD’s. Petitioner provided Teijin with a copy of petitioner’s quality manual to assist Teijin in making these revisions. Additionally, petitioner provided technical assistance to Teijin in the form of training Teijin personnel at petitioner’s U.S. facilities and providing ongoing manufacturing engineering assistance. Petitioner did not charge Teijin for this technical assistance or for providing its quality manual.

For the first 2 to 3 years of production of CSD’s by Teijin, it experienced a scrap rate of about 10 percent. Teijin reduced this rate gradually to about the 2-percent range.

Teijin purchased a number of finished CSD parts from petitioner for its CSD unit production. During 1977 and 1978, Teijin’s purchases amounted to about $281,000 and $711,000, respectively. CSD parts purchased from petitioner made up approximately 20 percent of the content of Teijin’s CSD units. Teijin paid petitioner the full catalog price, or equivalent thereof, for the CSD parts purchased from petitioner in 1977 and 1978.

B. The Siemens License

On September 28, 1970, petitioner and Siemens, a West German corporation, entered into a license agreement (hereinafter referred to as the Siemens license). Under the Siemens license petitioner gave Siemens, among other things, the exclusive right to manufacture CSD’s in Germany; the nonexclusive right to sell CSD’s manufactured by Siemens for original installation on aircraft manufactured in certain countries; 32 and the nonexclusive right to sell throughout the world replacement CSD’s and spare parts for CSD’s manufactured and sold by Siemens, and to sell parts to other CSD licensees of petitioner.

Siemens agreed to pay to petitioner for the Siemens license and services to be rendered, in addition to royalties, a lump-sum payment of $75,000 for each aircraft program (not to exceed in the aggregate $300,000) for which Siemens received the contract to furnish CSD’s, perform development, technical studies or tests for CSD’s, or perform repair and/or overhaul of CSD’s; or if earlier, after the lapse of a specified number of months. Failure by Siemens to make the lump-sum payment within the specified period converted the exclusive rights to nonexclusive rights and limited petitioner’s duty to furnish information, data, and services.

Siemens also agreed to pay to petitioner a royalty of 6.5 percent of the net selling price of all CSD’s, replacement CSD’s, and spare parts sold by Siemens; charges for technical studies, tests, mockup systems, and tooling relating to CSD’s; and charges for repair and/or overhaul of the CSD’s (including parts and labor).

The Siemens license was for a term of 15 years from receipt of the first lump-sum payment. It could be extended for one or more periods of 5 years each.

C. The IAI License

On November 20, 1970, petitioner gave Israel Aircraft Industries Ltd. (hereinafter referred to as IAI) the following options pertaining to CSD model number 15HD06:

(1) Upon payment of 90 percent of $10,000, the exclusive and perpetual right to use the technical information supplied by petitioner to assemble and test, use, sell, and/or transfer in Israel for or to the Government of Israel and/or its designee the CSD units and/or for the use in aircraft manufactured and/or modified in Israel; and the perpetual nonexclusive right to use, sell, and/or transfer throughout the world all such CSD units so assembled and tested by IAI for that aircraft and for aircraft manufactured and/or modified under the contract or license from Israel (the assembly license).

(2) Upon payment of 90 percent of $64,000, the exclusive and perpetual right to use the technical information and data supplied by petitioner to manufacture, and have manufactured, use, sell, and/or transfer in Israel to the Government of Israel and/or its designee parts for CSD units for use as spares and/or for use in aircraft manufactured and/or modified in Israel; and the perpetual, nonexclusive right to use, sell, and/or transfer throughout the world all such spare parts for that aircraft and for aircraft manufactured and/or modified under contract or license from Israel (the spare parts license).

(3) With the exercise of both options (1) and (2) and the payment of $74,000 (for the partial CSD manufacturing license) 33 or $99,000 (for the complete CSD manufacturing license), 34 less credits for all sums paid for the exercise of the other options, the exclusive and perpetual right to use the technical information and data supplied by petitioner to manufacture, and have manufactured, assemble, test, use, sell, and/or transfer in Israel to the Government of Israel and/or its designee CSD units and parts for them and/or for use in aircraft manufactured and/or modified in Israel; and the perpetual, nonexclusive right to use, sell, and/or transfer throughout the world all such CSD units and parts so manufactured by IAI for that aircraft and for aircraft manufactured and/or modified under contract or license from Israel.

The IAI license provides for a royalty of 6.5 percent of the net selling price to be paid to petitioner for a period of 10 years for the rights, services, and assistance provided under the IAI license. IAI also agreed to pay petitioner $1,000 to bring the IAI license into effect.

In addition, IAI agreed to pay petitioner $175 per day for each technical representative petitioner furnished to assist IAI in the implementation and use of the technical information and data supplied under each option. It further agreed to pay an additional sum to be agreed upon for assistance given to IAI in arranging favorable terms with suppliers and/or subcontractors who supply materials and/or parts to petitioner for use for or in the CSD units or any part for them.

D. The Licensintorg License

Petitioner entered into a license agreement with a Soviet organization, Vsesojuznoje Exportno-Importnoje Objedinenije (hereinafter referred to as Licensintorg), on August 31, 1976 (hereinafter referred to as the Licensintorg license). The Licensintorg license gave Licensintorg the exclusive and perpetual right to use, without limitation, in the U.S.S.R. the technical documentation and information supplied by petitioner to manufacture and have manufactured in the U.S.S.R. the CSD’s, and the required replacements and spare parts for them, and to use and sell in the U.S.S.R. the CSD’s, and the required replacements and spare parts for them, for use in commercial transport aircraft manufactured in the U.S.S.R.; the nonexclusive and perpetual right to use and sell in the People’s Republic of Bulgaria, the Hungarian People’s Republic, the Czechoslovak Socialist Republic, the Socialist Republic of Rumania, the Polish People’s Republic, the Socialist Federal Republic of Yugoslavia, and the German Democratic Republic CSD’s manufactured by Licensintorg in the U.S.S.R. for original installation in commercial transport aircraft manufactured in those countries; and the nonexclusive and perpetual right to use and sell in any country of the world replacement CSD’s and spare parts for the CSD’s sold by Licensintorg pursuant to the Licensintorg license. In lieu of a continuing royalty payment, Licensintorg paid petitioner in a lump sum $2,720,000 for the exclusive rights granted and the transfer of technical documentation and information and $480,000 for the nonexclusive rights granted, the technical assistance to be provided, the improvements and related technical documentation and information to be provided, and the liabilities and services to be provided.

The Licensintorg license was for 8 years (except for the perpetual licenses and provisions for improvements and related technical documentation and information and technical assistance which generally was for 5 years) but could be extended by mutual consent.

XI. THE CONSIGNMENT AGREEMENT

Petitioner originally planned to have SunPac distribute SunPac parts directly to its airline customers. Consequently, by letter dated June 16, 1977, petitioner announced to its commercial airline customers that it had established a facility in Singapore for the manufacture of spare parts and that effective November 1, 1977, it was instituting a method for shipping SunPac parts directly from Singapore while its Rockford facility would continue to handle all the paperwork.

The airline customers for the most part reacted negatively to petitioner’s direct distribution proposal. By letter dated December 7, 1977, the Association of European Airlines (hereinafter referred to as AEA) advised petitioner that, because of their lack of faith in the distribution system and the lack of proof of any real advantage to the airlines, the AEA rejected both petitioner’s proposal to supply material directly from Singapore and its alternative proposal for delivery of material f.o.b. Amsterdam for collection and distribution to the European airlines.

A. SABENA

Monsieur Michel DeSmedt (hereinafter referred to as Mr. DeSmedt) was general manager of SABENA’s purchasing department between 1970 and 1978. SABENA is an unrelated Belgian corporation with its principal place of business in Brussels, Belgium.

Mr. DeSmedt wanted to enter into consignment arrangements with aerospace manufacturers so that SABENA would have a wide range of aerospace spare parts to offer to airlines. In 1974, Mr. DeSmedt negotiated with Boeing to allow him to function as a distributor of Boeing spare parts in Europe.

During the 1970s, petitioner had poor product support in Europe. As a result, Mr. DeSmedt viewed petitioner as a prime candidate for his distribution concept. Mr. DeSmedt offered to have SABENA act as petitioner’s distributor of spare parts in Europe. Petitioner, however, on May 6, 1976, initially rejected Mr. DeSmedt’s offer.

In March 1978, SABENA once again approached petitioner and offered to store and distribute petitioner’s parts to the European airlines. Mr. DeSmedt entered into negotiations with petitioner and SunPac in June and July of 1978. He proposed to petitioner and SunPac a contract similar to SABENA’s contract with Boeing.

B. The Agreement

On August 15, 1978, but as of August 1, 1978, petitioner, SunPac, and SABENA entered into an agreement (hereinafter referred to as the consignment agreement) regarding the consignment and sale of spare parts to airlines in Europe, the Middle East, and Africa. SABENA agreed to act as consignee for certain parts for both SunPac and petitioner. The consignment agreement was to be in force for 3 years, subject to a 1-year extension.

The consignment agreement recites as follows:

At SABENA’s request, [SunPac] and [petitioner] have given consideration to consigning an inventory of certain spare parts most relevant to [SunPac’s] and [petitioner’s] customers operating in Europe, the Middle East and Africa. These parts are applicable to all models of [CSD’s] and other products manufactured by [petitioner] * * * .

In consideration of the consignment of spare parts by SunPac and petitioner, SABENA agreed to provide storage at its facilities in Brussels, Belgium, at no charge to SunPac or petitioner, and to perform from time to time, on a job order basis, certain modifications and rework of the spare parts as requested by petitioner and/or SunPac. The price for each job was not to exceed the sum of (1) a charge for labor at the direct labor hourly rate to be negotiated between the parties; and (2) the invoice cost to SABENA of any direct materials incorporated in the rework or modification (other than parts, kits, and materials, supplied by SunPac and/or petitioner and parts withdrawn from the consignment inventory) plus a handling charge equivalent to the rate of commission in effect at the time of the work. The price for the work, however, was not to exceed the customary charges made by SABENA to third parties for similar work.

Under the consignment agreement, SunPac and petitioner agreed to provide to SABENA an initial inventory of certain parts within 60 to 90 days of the execution of the consignment agreement. Additions, deletions, and replenish-ments of that inventory would be at petitioner’s and/or SunPac’s discretion based on sales activities and SABENA’s recommendation. The only requirement imposed by SABENA was a request that all parts turn over no more than three times per year. No semifinished parts were included in the SABENA consignment inventory.

SunPac and/or petitioner retained title to the spare parts until SABENA needed the part itself or received an order from one of SunPac’s or petitioner’s customers, at which time SABENA took ownership of the part and then used it or resold it to the customer. Consequently, SABENA bore no inventory carrying costs and avoided Belgian taxes and duties. SABENA undertook guardianship of the parts and took responsibility for insuring them. SABENA agreed to purchase SunPac parts f.o.b. Singapore and petitioner’s parts f.o.b. Rockford with SABENA to assume all shipping costs including transit insurance. Only FAA PMA parts could be sold to SABENA.

Under the consignment agreement, SunPac and petitioner agreed to pay quarterly to SABENA a commission fee for costs incurred in connection with the administration of the consignment inventory as follows:

Annual purchases (in U.S. dollars) Fee

Under $1.5 million.10.0%

1.5 million to 2.999 million. 8.0

3.0 million to 3.999 million. 6.5

4.0 million to 4.999 million. 5.0

5.0 million to 5.999 million. 4.5

6.0 million and over. 4.0

SABENA agreed to purchase spare parts from SunPac and/or petitioner at the prices in petitioner’s spare parts price list in effect at the time SABENA withdrew the part from the consignment inventory. SABENA’s suggested resale prices also were the prices in petitioner’s current spare parts price list. The sale of parts by SunPac and petitioner to SABENA at the catalog price was mandated by the World Airlines Suppliers’ Guide, which prohibits price discrimination.

The consignment agreement requires SABENA to make payment to SunPac and petitioner within 30 days of its purchase of the part. The parties delayed the effective date of the consignment agreement until January 1, 1979.

In conjunction with executing the consignment agreement for SABENA, Mr. DeSmedt inspected the SunPac facilities and concluded that the SunPac facilities were considerably better than petitioner’s facilities in Rockford.

C. SABENA’S Expenses and Operations Under the Consignment Agreement

1. Expenses

When SABENA entered into the consignment agreement, SABENA anticipated that it would not engage in any marketing or promotion activity with respect to the sale of the CSD parts since, when an airline company purchases an airplane, the CSD is supplier-furnished equipment (equipment over which the airline has no choice of selection). An airline would have to modify the entire engine to change the selection of the CSD, which is a costly undertaking. Thus, the airline is virtually “stuck with” the supplier-furnished CSD and there is no need to promote that part.

SABENA’s labor costs in performing under the consignment agreement are minimal because the clerical work is computerized.

2. Operations

SunPac made the first shipment of its parts to SABENA in October 1978 on board a SABENA airplane. During 1978, SunPac shipped to SABENA SunPac parts with a 1978 catalog value of $247,786.

SABENA performs order processing and order administration functions under the consignment agreement. Eighty percent of SABENA’s purchase orders are received by telex. The remaining 20 percent of the orders are received via open purchase orders. SABENA’s principal customers are overhaul and repair centers, which typically are operated by the airlines themselves.

D. Petitioner’s World Market after Entering into the Consignment Agreement

After entering into the consignment agreement, petitioner’s world market for CSD’s was divided into three regions, with warehouses in each region, as follows:

(1) Singapore — -the Far East region: Japan to Australia.

(2) Brussels — the European Region: Europe, Africa, the Middle East, including Pakistan and India. (Customers in the European region, however, could also buy from Singapore.)

(3) Rockford — the Americas region: North, South, and Central America, including Hawaii.

XII. OTHER SALES/DISTRIBUTION AGREEMENTS

In addition to the consignment agreement, petitioner entered into other sales or distributor agreements relating to products manufactured by petitioner’s aviation division.

A. NISSHO

Petitioner and Nissho entered into a sales agreement in September 1964 which was canceled and replaced by an agreement entered into in September 1967 (hereinafter referred to as the 1967 agreement). The 1967 agreement appointed Nissho as petitioner’s exclusive sales representative (except for sales made by petitioner’s employees) for the sale in Japan of CSD’s and standard equipment provided with them, aircraft hydraulic motors and pumps and their accessory equipment, and aircraft starters, manufactured by petitioner’s aviation division (hereinafter collectively referred to as the products) generally for aircraft built in Japan; military type aircraft owned, built, or modified by or for the Government of Japan; and aircraft built in countries other than Japan which do not use the products manufactured by petitioner. Petitioner agreed to pay Nissho a commission on its sales of the products as follows:

(a) Five percent (5%) of the commission net selling price on the first One Million Dollars ($1,000,000.00) of such sales made by [Nissho] since September 22, 1964;

(b) For such sales in excess of One Million Dollars ($1,000,000.00), three percent (3%) of the commission net selling price.

The 1967 agreement was amended on July 25, 1968, to extend the 5-percent commission to all sales unless petitioner advised Nissho that the 3-percent commission must be used. The 1967 agreement was further amended to include the sale of aircraft actuating systems (June 28, 1972), Pesco Products (June 18, 1973), see infra, Vap-Air Products (March 8, 1976), see infra, and Task Products (June 1, 1977), manufactured by petitioner’s aviation division. The term of the 1967 agreement was 3 years but it was to continue thereafter for additional 3-year periods unless canceled by written notice given at least 3 months before the end of the applicable 3-year period.

B. Mikuni

Petitioner entered into a purchase agreement with the Borg-Warner Corp. (hereinafter referred to as Borg-Warner) dated December 10, 1971, but not to be consummated before June 1, 1972, providing for the acquisition by petitioner of all the products of Borg-Warner’s Pesco Products Division (hereinafter referred to as Pesco Products). On June 1, 1972, petitioner entered into an agreement (hereinafter referred to as the Mikuni agreement) with Mikuni Shoko Co., Ltd. (hereinafter referred to as Mikuni) to continue a marketing services agreement Mikuni had entered into with Borg-Warner pertaining to Pesco Products. In the Mikuni agreement, petitioner and Mikuni agreed that Mikuni would provide sales representation services in Japan for Pesco Products for Japanese military and space vehicle applications and Pesco Product applications originating in Japan for a commission of 5 percent of the invoice price, f.o.b. factory, exclusive of all taxes, duties, insurance, tariffs, handling, shipping, and delivery charges. The initial term of the Mikuni agreement was 1 year but it was to continue indefinitely thereafter unless either party gave a 90-day written notice of termination.

C. Other Pesco Products Agreements

1. Avio-Diepen

. On October 4, 1972, petitioner entered into an agreement with Handelmaatschappij Avio-Diepen N.V. (hereinafter referred to as Avio-Diepen), a company organized under the laws of Holland, wherein petitioner gave Avio-Diepen the nonexclusive right to sell in certain listed countries in Europe, all countries of Africa, and all countries of the Middle East except Israel, certain Pesco Products replacement units and spare parts manufactured by petitioner in the United States for support of original installation Pesco Products (hereinafter referred to as the Avio-Diepen agreement). In article III of the Avio-Diepen agreement, petitioner agreed to give Avio-Diepen the following discounts: (1) 20 percent of the net selling price of spare parts for Pesco Products; and (2) 10 percent of the net selling price of replacement Pesco Products. The Avio-Diepen agreement defines “net selling price” as “the price quoted by [petitioner] for Spare [Pesco] Products ordered by [Avio-Diepen] from [petitioner] free on board [petitioner’s] factory, less any quoted quantity discount, taxes, duties, insurance, tariffs and handling, shipping and delivery charges, but not less any quote discounts pursuant to article III hereof.” The term of the Avio-Diepen agreement was 1 year but it was to continue indefinitely thereafter unless either party gave a 90-day written notice of termination. Petitioner terminated the Avio-Diepen agreement effective September 1, 1974.

2. Standard Aircraft

Sometime in 1972, petitioner entered into an agreement with Standard Aircraft Equipment, Inc. 35 (hereinafter referred to as Standard Aircraft) wherein. petitioner gave Standard Aircraft the nonexclusive right to sell in the United States, Mexico, South America, and Central America certain Pesco Products replacement units and spare parts manufactured by petitioner in the United States for support of original installation Pesco Products (hereinafter referred to as the Standard Aircraft agreement). In article III of the Standard Aircraft agreement, petitioner agreed to give Standard Aircraft the following discounts: (1) 20 percent of the net selling price of spare parts for Pesco Products; and (2) 10 percent of the net selling price of replacement Pesco Products. Net selling price is defined in the same manner as in the Avio-Diepen agreement. The Standard Aircraft agreement also was for a l-year term, continuing indefinitely thereafter unless terminated by written notice. Petitioner terminated the Standard Aircraft agreement effective September 1, 1974.

3. Hawker De Havilland

On April 20, 1973, petitioner entered into an agreement with Hawker De Havilland Australia Pty. Ltd. (hereinafter referred to as Hawker De Havilland) wherein petitioner gave Hawker De Havilland the nonexclusive right to sell in Australia, New Zealand, Singapore, Malaysia, Indonesia, Thailand, Burma,. Laos, Cambodia, Vietnam, and the Philippines certain Pesco Products replacement units and spare parts manufactured by petitioner in the. United States for support of original installation Pesco Products (hereinafter referred to as the Hawker De Havilland agreement). In article III of the Hawker De Havilland agreement, petitioner agreed to give Hawker De Havilland the following discount: (1) 20 percent of the net selling price of spare parts for Pesco Products; and (2) 10 percent of the net selling price of replacement Pesco Products. Net selling price is defined in the samé manner as in the Avio-Diepen agreement. The Hawker De Havilland agreement also was for a l-year term, continuing indefinitely thereafter unless terminated by written notice.

4. Secondo Mona

On July 3, 1974, petitioner proposed giving to Secondo Mona, located in Italy, a commission of 7.5 percent of the selling price of “ ‘Pesco’ type support part orders placed directly with [petitioner], except those orders for licensed product parts,” payable quarterly within 60 days after the end of each applicable calendar quarter. Payments from Secondo Mona were due 90 days after date of invoice. This arrangement was terminable at any time upon written notice. Secondo Mona accepted petitioner’s proposal on July 30, 1974.

5. Pierburg

Similarly, on September 23, 1974, petitioner offered to give Pierburg Luftfahrtgerate Union GMBH (hereinafter referred to as Pierburg), located in West Germany, a fee of 7.5 percent of the net selling price of Pesco-type fluid pumping repair parts Pierburg ordered directly from petitioner, payable quarterly within 60 days after the end of each applicable calendar quarter. This arrangement also was terminable at any time upon written notice. Pierburg accepted petitioner’s offer on September 30, 1974.

D. Mitsubishi Shoji

Petitioner acquired the products of the Vap-Air division of the Vapor Corp. (hereinafter referred to as Vapor) on September 2, 1975. On October 1, 1968, Mitsubishi Shoji Kaisha Ltd. (hereinafter referred to as Mitsubishi Shoji) had entered into a distribution agreement with Vapor International, a division of Vapor, wherein Vapor appointed Mitsubishi Shoji the exclusive sales distributor in Japan for Vap-Air division air valves, temperature controls, static inverters, battery chargers (collectively Vap-Air Products) for application in aircraft manufactured and/or repaired in Japan and replacements for them (hereinafter referred to as the Vap-Air Products agreement). Mitsubishi Shoji agreed to service the Vap-Air Products it or Vapor sold in Japan. Vapor agreed to pay Mitsubishi Shoji a commission of 10 percent of the f.o.b. invoice price (exclusive of freight, insurance, packing, duty, and sales taxes) on sales of Vap-Air Products except for sales of spares sold to Japan Air Lines for which the commission would be 5 percent of the net f.o.b. invoice price. The Vap-Air Products agreement initial term was 2 years, but it was to continue year to year thereafter unless terminated by either party by a written notice of termination.

Although the record is not clear as to this point, apparently petitioner continued for an indeterminable time the contractual relationship with Mitsubishi Shoji pertaining to Vap-Air Products. We note, however, that the parties have stipulated that petitioner incurred commission expenses under its agreement with Mitsubishi Shoji during 1975, 1976, and 1977. We note, further, that petitioner and Nissho amended the Nissho 1967 agreement on March 8, 1976, to include the sale of Vap-Air Products, see supra.

XIII. RESPONDENT’S ADJUSTMENTS

A. The Pricing Issue

1. The International Examiner’s Report

Respondent examined petitioner’s corporate Federal income tax returns for 1976, 1977, and 1978 (hereinafter referred to as the examination). Agent Edmund Pierson (hereinafter referred to as Agent Pierson) was respondent’s international examiner assigned to the examination. In connection with his examination of the intercompany pricing arrangement between petitioner and SunPac, Agent Pierson made a functional analysis of CSD operations performed by petitioner and SunPac. Agent Pierson determined that petitioner’s and SunPac’s duties (ranked in order of profit contribution) were as follows:

1. Owner of the CSD market (monopoly/sole source

supplier) petitioner

2. Inventor of the CSD petitioner

3. Original equipment manufacturer of CSD’s petitioner

4. Corporate owner and manager of business petitioner

5. Owner and supplier of technical know-how petitioner

6. Supplier of key materials petitioner

7. Provider of prime service and parts to users petitioner

8. Job shop producer of certain petitioner-proprietary petitioner

CSD parts and SunPac

As a result of the examination, Agent Pierson concluded that the pricing arrangement between petitioner and SunPac was not at arm’s length. In the portion of the revenue agent’s report prepared by Agent Pierson (hereinafter referred to as the international examiner’s report), Agent Pierson states the following:

Highly skilled precision machine shops in the aircraft field will endeavor to earn a gross margin of cost plus 22% to cost plus 38%. The size of the profits vary with ability, equipment, know-how, size of production runs, consignment practices, and tooling requirements. On the other hand, [petitioner] pays Sun[P]ac the spare parts list price less 15% for each part, f.o.b. Singapore. Sun[P]ac thereby earned gross margins of cost plus 157% in 1977 and cost plus 280% in 1978.

Respondent, therefore, proposed decreasing petitioner’s cost of sales for 1977 and 1978, and correspondingly increasing petitioner’s income, by $3,273,000 and $12,438,000, respectively, to reflect the amount he determined petitioner should have paid SunPac for the SunPac parts petitioner purchased in those years. The international examiner’s report, in part, explains the basis for this adjustment as follows:

[I]t is crystal clear that Sun[P]ac’s profits should be limited to the value of its contribution as a supplier of [petitioner]-proprietary CSD parts— and no more. The remainder should be reported as the income of [petitioner].

Since [petitioner] uses a unique pricing system for the purchase of CSD parts from Sun[P]ac, a pricing adjustment is being proposed. Sun[P]ac’s equipment and manufacturing abilities are not qualitatively different than those of subcontractors of precision machined parts in the aviation industry. It follows that the price of Sun[P]ac’s output should be similar to those that would be charged by the subcontractors dealing at arm’s length with [petitioner]. [Petitioner] does not give the rights to its market, ownership of its proprietary technical information, or unusually high markups to unrelated subcontractors. Therefore, [petitioner] should not be allowed to do so with Sun[P]ac.

Since neither the comparable uncontrolled price method nor the resale price method were applicable, the cost plus method. was used to determine the arm’s length price of Sun[P]ac’s output. * * * The economist’s report [see infra] recommended that [petitioner’s] sales of raw materials and semi-finished parts to Sun[P]ac not be included in Sun[P]ac’s cost structure, but that recommendation could not be followed. The reason is simple. Our set of comparable firms reported materials and semi-finished parts in their cost of goods sold and, for the sake of retaining comparability, we have allowed Sun[P]ac to keep its merchandise purchases in its cost of goods sold. This action benefits the taxpayer inasmuch as it inflates Sun[P]ac’s reported costs and the profits which are a function of those reported costs. With respect to the gross profits percentage, we have allowed Sun[P]ac a gross profit margin of 28% which is equal to the highest margin found in our set of generally comparable firms. This profit margin translates to a markup of cost plus 38%. Again, our choice of markup figure is generous. The net effect of our pricing adjustment is to allow Sun[P]ac an operating profit of 17% for 1977 and 21% for 1978.

In summary, we have established that the proper pricing method between [petitioner] and Sun[P]ac is cost plus, because Sun[P]ac is making [petitioner] parts, for [petitioner], to [petitioner] specifications. This would generate a bid quote to [petitioner] of either a flat rate per unit or a cost plus with a cap. Competition would not allow an excessive quote by Sun[P]ac if they were an unrelated party as [petitioner] knows what it takes and costs to produce the parts. There are many Sun[P]ac type shops available to [petitioner] and more than fair price contracts are not let by [petitioner].

Respondent also proposed to decrease petitioner’s income for 1977 and 1978 by $135,000 and $396,000, respectively, to reflect the elimination of royalty payments in those years. The international examiner’s report explains this adjustment in part as follows:

[Petitioner] had no licensing agreements with the parties which fabricate [petitioner]-proprietary parts. The firms that have this parts supplier role are subcontractors. They do not pay a royalty to [petitioner] for the use of [petitioner’s] designs, engineering drawings, specifications, and patents; nor do they have the right to ship their output to anyone but [petitioner]. Thus, [petitioner’s] arm’s length dealings with subcontractors do not reveal an appropriate royalty rate for [petitioner]-Sun[P]ac.

Given the absence of comparable royalty rates for the use of [petitioner’s] manufacturing and marketing intangibles, it has been decided that Sun[P]ac need not compensate [petitioner] with royalty payments. Instead, [petitioner] will be compensated through the intercompany pricing of Sun[P]ac’s output. The decrease in [petitioner’s] income as a result of the disallowance of Sun[P]ac’s royalty payments will be more than offset by the increase in [petitioner’s] income as a result of the reduction in the purchase prices for Sun[P]ac’s output.

In the cost-plus price method proposed by Agent Pierson, SunPac’s cost base is not increased for any amount to reflect location savings attributable to SunPac’s manufacturing its products in Singapore rather than in the United States. At the trial, Agent Pierson explained his reasons for not including an element for location savings as follows:

I tried to get some information on labor savings, and I weighed it with excess costs. I came to the conclusion that in this period of time, there were no significant labor — there were no significant location savings.

I had a high construction for the building because everything had tó be imported. I had a lot of landfill. I had employees who were learning and had a lot of rework and a big learning curve. So I didn’t have Class A producers right off the bat. So that was a hindrance.

I had a lot of expensive units that were well along the way in production that were shipped over there, and they told me those went air freight. That’s abput $6 a pound. So I had a lot of freight, excess freight, going over and coming back.

So just without getting into severe details, I made a judgment there were no significant labor or location savings. I would have gladly gone into it in great depth had I been given the information.

At some point during the examination of the years in issue, petitioner refused to respond to any further requests for information made by respondent’s agents. Respondent did not issue any administrative summons to obtain this additional information.

2. The Economist’s Report

During the examination, Agent Pierson used the services of Robert S. Marek (hereinafter referred to as Mr. Marek), one of respondent’s staff economists. Mr. Marek prepared an economic analysis of petitioner for 1977 and 1978 (hereinafter referred to as the Marek report), upon which Agent Pierson relied in part for his conclusion that the pricing arrangement between petitioner and SunPac was not at arm’s length.

According to the Marek report:

The intercompany pricing system [between petitioner and SunPac] does not recognize that [SunPac] is functionally equivalent to a subcontractor. Nor does the intercompany pricing system require that [petitioner] deal with [SunPac] in the same manner it [sic] deals with unrelated subcontractors. Consequently, it is recommended that the following pricing adjus

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