# Eli Lilly & Co. v. Commissioner

> United States Tax Court · May 28, 1985 · 84 T.C. 996

URL: https://www.frixlaw.com/law-library/cases/4622015

## Case

- **Full name:** Eli Lilly and Company and Subsidiaries v. Commissioner of Internal Revenue
- **Court:** United States Tax Court
- **Decided:** May 28, 1985
- **Citations:** 84 T.C. 996; 84 T.C. No. 65; 1985 U.S. Tax Ct. LEXIS 73
- **Precedential status:** Published
- **Opinion:** Opinion
- **Judges:** Wiles
- **Cited by:** 28 later opinions in the Frix Law Library

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## Opinion text

Eli Lilly and Company and Subsidiaries, Petitioners v. Commissioner of Internal Revenue, Respondent
Eli Lilly & Co. v. Commissioner
Docket No. 5113-76
United States Tax Court
84 T.C. 996 ; 1985 U.S. Tax Ct. LEXIS 73 ; 84 T.C. No. 65 ;
May 28, 1985 ; Affirmed in part; Reversed in part and Remanded August 31, 1988 May 28, 1985 , Filed
*73 Decision will be entered under Rule 155 .
CONTENTS Page
Headnote 999
Introduction and Statement of Issues 1001
Findings of Fact 1002
I. History and Background of Eli Lilly & Co. 1002
A. Petitioner 1002
B. Lilly P.R. 1004
II. History and Background of Darvon and Darvon-N Products 1004
A. Propoxyphene and Propoxyphene Hydrochloride 1004
B. Propoxyphene Napsylate 1006
C. Success of Darvon and Darvon-N Products 1007
III. Manufacture of Darvon and Darvon-N Products 1009
A. Overview of Petitioner's Manufacturing Operations 1009
B. Manufacture of Darvon Products 1010
C. Manufacture of Darvon-N Products 1012
D. Development of Manufacturing Know-How 1012
1. Chemical Manufacture 1012
2. Pharmaceutical Manufacture 1014
E. Foreign Manufacture of Propoxyphene Products 1015
IV. Historical Development of the Puerto Rican Operations of
Petitioner and Lilly P.R. 1015
A. Puerto Rico's "Operation Bootstrap" 1015
B. Petitioner's 1961-62 Study of Possible Puerto Rican
Operations 1016
C. Petitioner's Second Puerto Rican Study 1965-66 1017
V. Lilly P.R.'s Puerto Rican Tax Exemptions 1025
VI. Background and Documents Concerning Lilly P.R. 1027
A. Organization of Lilly P.R. and Initial Capitalization 1027
B. Technical Assistance Agreement 1027
C. Private Letter Ruling 1028
D. Assignment of Patents and Manufacturing Know-How 1031
E. Distribution Agreements 1034
F. Joint Research Agreement 1035
G. Agreements Regarding Empty Capsules 1037
VII. Lilly P.R.'s Manufacturing Activities 1037
A. Temporary Leased Facility 1037
B. Carolina Facility 1038
C. Mayaguez Facility 1039
D. Personnel 1040
1. Organization of Initial Work Force 1040
2. Training of Employees 1041
3. Board of Directors, Officers, and Management
Committees 1042
4. 1971-73 Lilly P.R. Personnel 1042
E. Manufacturing Activities 1971-73 1042
1. Production Planning 1042
2. Chemical Manufacturing at Mayaguez 1043
3. Pharmaceutical Manufacturing at Carolina 1045
F. Manufacturing Tickets and Related Procedures 1046
G. Raw Material Purchases 1048
H. Equipment Purchases 1049
I. Technical Assistance 1049
J. Quality Control 1050
K. Sample and Identi-dose Packaging 1051
VIII. Petitioner's Marketing Operations 1051
A. Introduction 1051
B. Organization 1052
1. Marketing Research and Marketing Planning 1052
2. Sales Force 1053
C. Regulation of Promotional Claims 1055
D. Marketing of Darvon and Darvon-N Products 1056
E. Pricing of Darvon and Darvon-N Products 1056
F. Significance of Marketing Intangibles 1058
IX. Petitioner's Research and Development Activities 1060
A. Introduction 1060
B. Food and Drug Administration Requirements 1064
C. Research and Development of Propoxyphene Products
1967-73 1068
1. General 1068
2. Research Projects 1068
3. NDAs 1070
X. Litigation Related to Propoxyphene Products 1072
XI. Intercompany Pricing of Darvon and Darvon-N Products 1073
A. General 1073
B. Initial Pricing Policy 1076
C. Pricing Policy 1971-73 1078
XII. Financial Information 1080
A. Overview of Petitioner's Accounting System 1080
B. Lilly Research Laboratories' Accounting Systems 1081
C. Propoxyphene Research and Development Expenses 1083
1. Pre-1967 Research Activities 1083
2. 1967-73 Research Activities 1085
D. Lilly P.R. Financial Statements 1971-73 1086
E. Lilly P.R. Sales of Darvon and Darvon-N Products 1089
F. Petitioner's Pharmaceutical Division Income Statements 1089
G. Combined Income Statements for Darvon and Darvon-N
Products 1971-73 1091
1. General 1091
2. Lilly P.R. 1093
3. Petitioner 1094
a. Cost of Goods Sold 1094
b. Operating Expenses 1094
i. General Administration Expenses 1094
ii. Selling Expenses 1095
iii. Merchandising Expenses 1098
iv. Shipping Expenses 1098
H. Technical Assistance Fees 1098
I. Lilly P.R. Purchases From Petitioner 1099
1. Raw Materials 1099
2. Equipment and Machine Parts 1100
XIII. Generic Propoxyphene Products 1100
A. General 1100
B. Zenith Laboratories, Inc. 1101
C. Rachelle Laboratories, Inc. 1102
D. Smith Kline & French Laboratories 1102
1. Milan Pharmaceuticals, Inc. 1102
2. SK-65 Compound 1103
XIV. Respondent's Proposed Adjustments 1105
A. Notice of Deficiency 1105
B. Amendment to Answer 1107
Opinion 1107
Introduction 1107
Issue 1. Ownership of Intangibles for Section 482 Purposes 1108
A. Background of Relevant Provisions 1109
1. Tax Incentives for Companies Operating in Puerto
Rico 1109
a. Section 931 1109
b. Puerto Rico's Operation Bootstrap 1112
2. Nonrecognition Provision of Section 351 1113
B. Interrelationship of Section 482 and Sections 351 and
931 1114
1. Introduction 1114
a. History and Purpose of Section 482 1114
b. Scope of Respondent's Authority 1115
2. Income From Manufacturing Intangibles 1116
a. Section 482 Allocations Involving Nonrecognition
Transfers 1116
i. National Securities Corp. and Avoidance of
Taxes 1118
ii. Central Cuba Sugar, Rooney, Clear
Reflection of Income 1121
iii. Substance Over Form 1125
b. Arm's-Length Consideration 1127
Issue 2. Respondent's Section 482 Adjustments 1130
Issue 3. Determination of Arm's-Length Prices Between Petitioner
and Lilly P.R. 1133
A. Section 482 Regulations 1134
1. 1971 and 1972 Taxable Years 1134
a. Pricing Methods 1135
i. Comparable Uncontrolled Price Method 1136
ii. Resale Price Method 1136
iii. Cost Plus Method 1145
b. Profit Split Approach 1147
i. Cost of Goods Sold 1153
ii. Operating Expenses 1156
iii. Applicable Profit Split Percentage 1163
2. 1973 Taxable Year 1168
a. Comparable Uncontrolled Price Method 1169
i. Petitioner's Adjustments to Milan's Prices 1171
ii. Respondent's Expert Economic Evidence 1173
iii. Determination of Arm's-Length Price 1176
B. Revenue Procedure 63-10 1186
1. 1971 and 1972 Taxable Years 1186
2. 1973 Taxable Year 1191
*74 1. Petitioner is engaged in the manufacture and sale of pharmaceutical products. Petitioner created and patented propoxyphene hydrochloride (Darvon) during the early 1950's and propoxyphene napsylate (Darvon-N) during the early 1960's. Darvon was first introduced into the U.S. market in 1957, and was manufactured by petitioner from 1957 to 1966. Darvon-N was not introduced into the U.S. market until 1971 and was never manufactured by petitioner. In 1965, petitioner organized Lilly P.R. as a wholly owned Puerto Rican subsidiary qualifying for the benefits of sec. 931, I.R.C. 1954 . In December 1966, petitioner transferred the Darvon and Darvon-N patents and related manufacturing know-how to Lilly P.R. in a sec. 351, I.R.C. 1954 , nonrecognition transaction. After 1966 and throughout the years in issue, Lilly P.R. manufactured Darvon and Darvon-N for sale to petitioner who in turn marketed the products throughout the United States. Held , Lilly P.R.'s ownership of the manufacturing intangibles is recognized in determining arm's-length prices between Lilly P.R. and petitioner. Held, further , the *75 prices Lilly P.R. charged petitioner caused a distortion of income justifying reallocations.
2. Held , although reallocations of income were warranted, respondent's adjustments to prices under sec. 482 , which denied Lilly P.R. any income from the manufacturing intangibles, were unreasonable.
3. During 1971 and 1972, Lilly P.R. was the sole manufacturer of Darvon and Darvon-N. These drugs were nonnarcotic analgesics which competed in the prescription pain relief market with combinations of codeine with aspirin or acetaminophen. At the end of 1972, the Darvon patent expired and, shortly thereafter, several companies began to compete directly with Darvon by manufacturing and marketing generic propoxyphene hydrochloride products. Held , arm's-length prices determined for 1971 and 1972 under sec. 1.482-2(e)(1)(iii), Income Tax Regs. Held, further , arm's-length prices for 1973 determined under sec. 1.482-2(e)(2), Income Tax Regs.
Thomas M. Haderlein , John C. Klotsche , Michael Waris, Jr. , Gregg D. Lemein , Paul J. Linstroth , and James M. O'Brien , for the petitioners.
Joel V. Williamson , Charles S. Triplett , and Joseph R. Goeke , for the respondent.
Wiles , Judge .
WILES
*1000 Respondent determined *76 deficiencies in petitioners' Federal income taxes as follows: Year Deficiency
1971 $ 7,622,449
1972 7,340,867
1973 6,853,816
*1001 By amendment to his answer, respondent asserted increased deficiencies in the following amounts: Year Deficiency 1
1971 $ 11,711,792
1972 11,626,363
1973 10,882,192
The entire amounts of the deficiencies determined by respondent for 1971 and 1972 are in dispute, and petitioners claim refunds for 1971 and 1972 in the amounts of $ 1,700,038 and $ 1,697,257, respectively. For 1973, all but $ 189,048 of the deficiency determined by respondent is in dispute.
Pursuant to petitioners' motion, this Court severed from the case all issues other than the propriety of respondent's allocations of gross income under section 482 2 from Eli Lilly & Co., Inc. (hereinafter Lilly P.R.) to petitioner Eli Lilly Co. (hereinafter petitioner) with respect to Darvon Registered TM and Darvon-N Registered TM products. The severed issues were consolidated with docket No. 19606-80 for purposes of trial, briefing, and opinion; consequently, *77 a final decision as to the income tax deficiencies of petitioners for the taxable years 1971, 1972, and 1973 will not be possible based upon the opinion of this case.
The section 482 allocations of gross income from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products determined by respondent in his notice of deficiency and amendment to answer are as follows: Notice of Amendment
Year deficiency to answer
1971 $ 18,522,924 $ 26,620,387
1972 17,820,986 26,314,918
1973 10,717,187 18,078,205
These allocations raise the following questions for our consideration:
1. Whether petitioner's 1966 transfer pursuant to section 351 of certain Darvon and Darvon-N income-producing intangibles to Lilly P.R., a wholly owned subsidiary corporation *1002 engaged in manufacturing in Puerto Rico and qualifying as a possessions corporation within the meaning of section 931 , should be recognized for the purposes of determining arm's-length prices for Darvon and Darvon-N products purchased by petitioner from Lilly P.R. during 1971, 1972, and 1973;
2. Whether respondent's *78 determinations that gross income should be allocated from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products for the years 1971, 1972, and 1973 were arbitrary, capricious, or unreasonable;
3. Whether Lilly P.R.'s prices to petitioner for Darvon and Darvon-N products manufactured by Lilly P.R. and sold to petitioner during 1971, 1972, and 1973 were prices at which those products would have been sold between unrelated parties dealing at arm's length.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
I. History and Background of Eli Lilly & Co .
A. Petitioner
Petitioner is an Indiana corporation whose principal place of business at the time of filing the petition herein was Indianapolis, Indiana. During the years 1971, 1972, and 1973, petitioner and its consolidated subsidiaries maintained their books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Petitioner and its consolidated subsidiaries filed consolidated Federal income tax returns on Forms 1120 for the taxable years 1971, 1972, and 1973, at the Memphis Service Center, Memphis, Tennessee.
Petitioner is engaged in the *79 United States in the invention, development, manufacture, marketing, and sale of a wide variety of ethical (i.e., prescriptions) and other pharmaceutical products, as well as certain agricultural, chemical, and cosmetic products. Petitioner is engaged in similar activities in approximately 145 countries throughout the world through a network of approximately 70 partially and wholly owned domestic and foreign corporations. During the time period *1003 1960 through 1975, petitioner and its subsidiaries employed from 10,000 to 24,000 individuals.
During the years 1971 through 1973, the relevant divisions and subsidiaries of petitioner and their respective responsibilities were as follows:
(a) Pharmaceutical Division: Marketing and sale of pharmaceutical products in the United States.
(b) Elanco Products Co.: Marketing and sale of animal health and agricultural products in the United States.
(c) Elizabeth Arden, Inc.: Marketing and sale of cosmetic products in the United States.
(d) Lilly Research Laboratories: Fundamental and developmental research in the life sciences.
(e) Production Operations Division: Operation of all manufacturing facilities in the United States.
(f) Lilly P.R.: Manufacture *80 and sale of ethical pharmaceutical products in Puerto Rico.
(g) Lilly Industries Ltd.: Fundamental and developmental research in the life sciences and manufacturing, marketing, and sale of pharmaceutical, animal health, and agricultural products.
(h) Eli Lilly S.A., Geneva: International marketing, licensing, and holding company.
The consolidated net sales (excluding intercompany sales) of petitioner and its worldwide subsidiaries and the United States pharmaceutical net sales of petitioner for the years 1965 through 1973 were as follows (000's omitted): Consolidated U.S. pharmaceutical
Year net sales net sales
1965 $ 316,600 $ 176,358
1966 366,700 196,482
1967 408,400 212,829
1968 479,600 257,610
1969 537,200 284,501
1970 592,300 304,933
1971 723,300 338,321
1972 819,700 351,044
1973 972,500 368,915
During the years 1971 through 1973, approximately 60 percent of the consolidated sales of petitioner and its worldwide subsidiaries was attributable to the sale of pharmaceutical *1004 products. 3 During those years, petitioner marketed approximately 750 pharmaceutical products in the United States. Petitioner's pharmaceutical sales during that time accounted for approximately 7.5 percent of the total pharmaceutical industry *81 sales in the United States, and its pharmaceutical products accounted for approximately 6.5 percent of the new and refilled prescriptions written in the United States.
B. Lilly P.R .
Lilly P.R. was organized under the laws of the State of Indiana on June 9, 1965, as a wholly owned subsidiary corporation of petitioner. Lilly P.R.'s principal place of business is located in the Commonwealth of Puerto Rico. During 1971, 1972, and 1973, Lilly P.R. maintained its books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Lilly P.R. filed Federal income tax returns on Forms 1120 for the taxable years 1971 through 1973 with the Office of International Operations, Philadelphia, Pennsylvania.
Lilly P.R. was organized by petitioner, among other reasons, to take advantage of the benefits provided by section 931 relating to income from sources within possessions of the United States. Since its inception, Lilly P.R. has been engaged in the manufacture of propoxyphene and other pharmaceutical *82 products in the Commonwealth of Puerto Rico. During each of the years in issue, Lilly P.R.'s gross income satisfied the conditions set forth in subsections (1) and (2) of section 931(a) .
II. History and Background of Darvon and Darvon-N Products
A. Propoxyphene and Propoxyphene Hydrochloride
The search for a nonaddictive synthetic analgesic having the pain relieving properties of morphine began in the late 1920's and was accelerated in later years by two events. The first of those events was the scarcity of morphine during World War II. The second came at the close of World War II when American scientific intelligence teams investigated German *1005 wartime work on synthetic analgesics and published a report, referred to as the "Kleiderer Report," summarizing that work for the American scientific community. The Kleiderer Report dealt with a number of synthetic substances, one of which subsequently became known as methadone. Although methadone proved to be as effective an analgesic as morphine, it also proved to be as addictive as morphine. In response to the Kleiderer Report, an intensive research effort was mounted in the United States and abroad for a nonnarcotic, synthetic analgesic *83 of the morphine class. Several major pharmaceutical companies, including petitioner, participated in that effort.
In 1951, Dr. Albert Pohland, a research chemist working at Lilly Research Laboratories, discovered propoxyphene and propoxyphene hydrochloride. Propoxyphene hydrochloride, the principal active ingredient in Darvon products, proved to be the first synthetic analgesic that acted on the central nervous system with only a negligible potential of addiction. U.S. Patent 2,728,779 (hereinafter the propoxyphene patent) was issued to petitioner as Dr. Pohland's assignee on December 27, 1955, pursuant to an application filed on December 3, 1952. The propoxyphene patent covered the chemical substance propoxyphene and the acid addition salts of propoxyphene, including propoxyphene hydrochloride. The propoxyphene patent expired on December 27, 1972.
Propoxyphene is an oral prescription analgesic medication that relieves pain by acting upon the pain receptors in the brain. Propoxyphene is prescribed by physicians for the relief of mild to moderate pain, such as severe headache pain, postsurgical pain, and pain from bone fractures. It is often prescribed for patients with pain who *84 have unsuccessfully self-medicated with over-the-counter drugs such as aspirin and acetaminophen. 4 Aspirin and acetaminophen are peripherally acting analgesics that relieve pain by acting at the site in the body where the pain arises.
Although propoxyphene was discovered in 1951 and the propoxyphene patent was issued to petitioner in 1955, petitioner did not obtain its first approval to market a propoxyphene product in the United States from the Food and Drug Administration, Department of Health and Human Services (hereinafter *1006 the FDA) until September 9, 1957. Petitioner sold its propoxyphene hydrochloride products under the trademark Darvon, which trademark it registered on July 29, 1958.
During the period from 1957 through 1973, petitioner sold the following products containing propoxyphene hydrochloride as their principal active ingredient: Identification
code Description
PU 364 Darvon 32 mg.
PU 365 Darvon 65 mg.
PU 366 Darvon with A.S.A.
PU 368 Darvon Compound
PU 369 Darvon Compound-65
PU 377 Darvo-Tran Registered TM
TA 1855 Stero-Darvon Registered TM
The letters "PU" in the identification code *85 of a product indicate that the product is sold in capsule, or "Pulvule Registered TM," form. The letters "TA" indicate that the product is sold in tablet form. The propoxyphene hydrochloride products listed above are hereinafter referred to collectively as "Darvon products."
B. Propoxyphene Napsylate
Propoxyphene napsylate, another salt of propoxyphene, is a nonnarcotic analgesic closely related to propoxyphene hydrochloride. Propoxyphene napsylate was discovered by Dr. Verlin C. Stephens, a research chemist of Lilly Research Laboratories. U.S. Patent 3,065,261 (hereinafter the napsylate patent) was issued to petitioner as Dr. Stephens' assignee on November 20, 1962, pursuant to an application filed on December 14, 1960. The napsylate patent, covering the napsylate acid addition salts of propoxyphene, expired on November 20, 1979.
Propoxyphene napsylate and propoxyphene hydrochloride are medically identical as far as pain relief is concerned. However, because the molecular weight of propoxyphene napsylate is greater than that of propoxyphene hydrochloride, a dose of 100 milligrams of propoxyphene napsylate is required to supply an amount of propoxyphene equivalent to that present *86 in 65 milligrams of propoxyphene hydrochloride. Also, whereas propoxyphene hydrochloride is freely soluble in water, propoxyphene napsylate is only slightly soluble in *1007 water. As a result of that difference, the napsylate salt has certain advantages over the hydrochloride salt. First, suspension (i.e., liquid) and tablet formulations of the napsylate salt are more stable than those of the hydrochloride salt. The greater stability of the napsylate salt thus makes it easier to disguise propoxyphene's intensely bitter taste. Second, the napsylate salt does not react with aspirin and, as a result, combinations of aspirin and the napsylate salt do not present the same problems as those that occur in combinations of aspirin and the hydrocholoride salt. 5 *87 Finally, because the napsylate salt is less soluble than the hydrochloride salt, it is not absorbed into the bloodstream as quickly as the hydrochloride salt, which results in less stomach irritation than that occurring in some patients using the hydrochloride salt and which allows more time for emergency measures in overdose situations.
Petitioner obtained its first FDA approval to market a propoxyphene napsylate product in the United States on September 9, 1971. Petitioner sold its propoxyphene napsylate products under the trademarks Darvocet-N Registered TM and Darvon-N, which were registered by petitioner on January 1, 1973, and February 6, 1973, respectively.
During the years 1971 through 1973, petitioner sold the following products containing propoxyphene napsylate as their principal active ingredient: Identification
code Description
TA 1883 Darvon-N
TA 1884 Darvon-N with A.S.A.
MS 135 Darvon-N Suspension
TA 1890 Darvocet-N 50
The letters "MS" in the identification code indicate that the product is sold in the form of a liquid suspension. The propoxyphene napsylate products listed above are hereinafter referred to collectively as "Darvon-N products."
C. Success of Darvon and Darvon-N Products Darvon and Darvon-N products were the most often prescribed *1008 ethical pharmaceutical products in the United States during the period 1960 through 1973. During each of *88 the years 1958 through 1973, Darvon or Darvon-N products were among the 10 largest selling ethical pharmaceutical products in the United States.
During the years 1971 through 1973, Darvon and Darvon-N products competed in the market for medications for the relief of mild to moderate pain, and their principal competitors were combinations of codeine with aspirin, acetaminophen, or other peripherally acting analgesics. During the years 1958 through 1972, while the propoxyphene patent was in effect, Darvon and Darvon-N products occupied 100 percent of the propoxyphene market in the United States. In 1973, after the propoxyphene patent expired, Darvon and Darvon-N products occupied approximately 98 percent of the propoxyphene market in the United States.
Petitioner's sales of Darvon and Darvon-N products in the United States during the years 1958 through 1973 were as follows (000's omitted): Year Darvon Darvon-N Total
1958 $ 6,900 0 $ 6,900
1959 9,700 0 9,700
1960 14,000 0 14,000
1961 19,700 0 19,700
1962 24,800 0 24,800
1963 24,400 0 29,400
1964 36,700 0 36,700
1965 38,800 0 38,800
1966 44,600 0 44,600
1967 50,300 0 50,300
1968 60,400 0 60,400
1969 65,100 0 65,100
1970 69,300 0 69,300
1971 69,800 $ 4,100 73,900
1972 66,500 9,300 75,800
1973 53,400 16,600 70,000
Petitioner's *89 net income before taxes on U.S. sales of Darvon products for the years 1958 through 1965, based upon petitioner's method of allocating expenses, was as follows (000's omitted): *1009 Net income
Year before taxes
1958 $ 1,600
1959 4,200
1960 5,100
1961 13,000
1962 17,900
1963 22,200
1964 28,200
1965 30,200
Petitioner's and Lilly P.R.'s consolidated net income before taxes on U.S. sales of Darvon and Darvon-N products (Darvon-N products in 1971 through 1973 only) for the years 1966 through 1973, based upon petitioner's method of allocating expenses, was as follows (000's omitted): Net income
Year before taxes
1966 $ 32,700
1967 37,600
1968 43,700
1969 43,400
1970 47,100
1971 50,500
1972 49,100
1973 40,700
III. Manufacture of Darvon and Darvon-N Products
A. Overview of Petitioner's Manufacturing Operations
During the 1950's and 1960's, petitioner maintained bulk chemical manufacturing facilities in Indianapolis, Indiana, at which chemical synthesis, antibiotic fermentation, and insulin manufacturing operations were conducted. Pharmaceutical manufacturing operations (i.e., product formulation, encapsulation or tableting, and packaging), were also conducted at the Indianapolis facilities. In 1953, petitioner started an antibiotic *90 fermentation operation at its new Tippecanoe Laboratories facility in West Lafayette, Indiana. Chemical synthesis operations were begun at Tippecanoe Laboratories in 1958.
Because the manufacturing techniques and technology and the training of production personnel in chemical manufacturing are vastly different from those involved in pharmaceutical manufacturing, it is a common industry practice to physically *1010 separate chemical and pharmaceutical manufacturing operations. Chemical synthesis operations involve continuous reactions that cannot be stopped, thereby requiring 24-hour-a-day operations. They also entail water and air pollution problems, the handling of dangerous chemicals, and a substantial demand for utilities such as water and steam. Furthermore, chemical manufacturing operations are capital intensive. In contrast, pharmaceutical manufacturing operations are labor intensive, are conducted in very clean environments, and do not place a great demand on utilities or require 24-hour-a-day operations.
During the years 1971 and 1973, petitioner maintained separate chemical and pharmaceutical manufacturing facilities. Its pharmaceutical manufacturing operations were conducted *91 in its plants on Kentucky Avenue and McCarty Street in Indianapolis, Indiana, and its chemical manufacturing operations for pharmaceutical products were conducted at its plants in West Lafayette and Clinton, Indiana. The Clinton plant became operational in 1971.
B. Manufacture of Darvon Products
The manufacture of Darvon products consists of two distinct phases: (a) the chemical manufacturing phase, involving the production of the bulk chemical propoxyphene hydrochloride; and (b) the pharmaceutical manufacturing phase, involving formulating or mixing the bulk chemical with other active and/or inactive ingredients, encapsulating the formulated product or compressing it into tablets, and packaging and labeling the capsules or tablets.
Prior to full-scale commercial production of Darvon products, petitioner developed manufacturing techniques at its chemical and dry products pharmaceutical pilot plants in Indianapolis, Indiana. Petitioner's pilot plants were departments of Lilly Research Laboratories during the years 1955 through 1973.
The functions of petitioner's chemical pilot plant were to scale up the chemical manufacturing processes for new chemicals from laboratory quantities to commercial *92 quantities and to provide materials for clinical trials and toxicological testing. (Clinical trials and toxicological testing, both of which are important in the development and FDA approval of a new *1011 pharmaceutical product, will be discussed later in detail.) When a new chemical is first identified and undergoes its initial testing, only small quantities of the chemical are produced in the laboratory. The new chemical is transferred to the pilot plant for the development of an economical process for manufacturing the chemical in commercial quantities. The pilot plant development also identifies any special equipment that might be required to perform the process. When the chemical is placed in production at the chemical manufacturing plant, pilot plant personnel ordinarily will participate in the startup of the full-scale manufacturing process.
Upon the completion of pilot plant development of propoxyphene hydrochloride, petitioner in 1957 began full-scale commercial production of propoxyphene hydrochloride at a chemical manufacturing facility in Indianapolis, Indiana. The chemical manufacture of propoxyphene hydrochloride was transferred from Indianapolis to petitioner's Tippecanoe *93 Laboratories in West Lafayette, Indiana, in 1960. Chemical manufacture of other products had begun at Tippecanoe Laboratories as early as 1958, when petitioner designated that facility as its site for future expansion of chemical manufacturing. Eventually, petitioner closed its Indianapolis chemical manufacturing facility.
From 1960 through 1965, petitioner produced propoxyphene hydrochloride in various buildings at Tippecanoe Laboratories. As a result of its need for additional chemical manufacturing facilities, petitioner, in 1965, constructed a new building (called Building T28) to house the production of propoxyphene hydrochloride, which by then had become a substantial product. Building T28 was constructed at an approximate cost of $ 2 million and occupied 12,000 square feet, excluding warehouse and central services. From January 1, 1966, to December 5, 1966, 6 *94 bulk propoxyphene hydrochloride was produced in Building T28, requiring a total of approximately 20 direct manual and machine operators for all three 8-hour shifts plus numerous support and management personnel.
*1012 During the years 1957 through 1965, bulk propoxyphene hydrochloride was transported from the chemical manufacturing facility at either Indianapolis or Tippecanoe to petitioner's Kentucky Avenue plant in Indianapolis for use in the pharmaceutical manufacture of Darvon products. During that period, petitioner also manufactured the empty capsules for Darvon products at the Kentucky Avenue plant.
During the period 1957 to December 5, 1966, petitioner manufactured and sold Darvon products only in bottles of 100 and bottles of 500 capsules. The following Darvon products were manufactured and sold by petitioner during that period: Identification
code Description
PU 364 Darvon 32 mg.
PU 365 Darvon 65 mg.
PU 366 Darvon with A.S.A.
PU 368 Darvon Compound
PU 369 Darvon Compound-65
PU 377 Darvo-Tran
C. Manufacture of Darvon-N Products Darvon-N products were first sold by petitioner in 1971. Petitioner never commercially manufactured *95 bulk propoxyphene napsylate or Darvon-N products in the United States. The Darvon-N products sold by petitioner in 1971, 1972, and 1973 were manufactured solely by Lilly P.R.
D. Development of Manufacturing Know-How
1. Chemical Manufacture
As stated earlier, petitioner manufactured bulk propoxyphene hydrochloride from 1957 to December 5, 1966. The actual chemical synthesis involved was done in a six-step sequence: (1) Propiophenone, (2) iso butyro phenone derivative base, (3) carbinol derivative crude, (4) dextro carbinol camphor sulfonate, (5) dextro carbinol base, and (6) propoxyphene hydrochloride.
The processes and techniques used by petitioner to manufacture the bulk chemical propoxyphene hydrochloride generally were standard in the pharmaceutical industry. However, over a period of several years, petitioner in the chemical pilot plant of Lilly Research Laboratories and in its chemical manufacturing *1013 plants developed 7 *96 methods of production allowing increased batch size, fewer raw materials, and lower unit costs. As a result of petitioner's efforts, its cost of producing propoxyphene hydrochloride declined from about $ 125 per kilogram in 1957 to about $ 30 per kilogram in 1960.
The basic chemistry underlying each of the chemical reactions involved in the manufacture of propoxyphene hydrochloride is well known in the pharmaceutical industry. A skilled chemist could ascertain the basic chemical reactions involved once he knew the molecular structure of the final product. However, the details of the processes used by petitioner in carrying out those reactions could not be ascertained by analysis of the finished product and is not known outside of petitioner and certain of its subsidiaries.
The processes used by petitioner to manufacture propoxyphene hydrochloride were not discussed in the propoxyphene patent, and, in fact, the patent application was filed in 1952, long before the processes themselves were developed. The propoxyphene patent was not a so-called *97 "process" patent, but rather covered the chemical substances propoxyphene and propoxyphene hydrochloride, which are not produced until the sixth and final step. Petitioner did not attempt to patent the processes it developed to manufacture propoxyphene hydrochloride, which may or may not have been patentable, because process patents disclose the details of the processes they cover and are difficult and costly to enforce. Petitioner, instead, relied upon secrecy to preserve the value of the manufacturing know-how involved in its manufacture of propoxyphene hydrochloride.
Petitioner disclosed its manufacturing know-how to production employees in documents called manufacturing or work tickets, which contained detailed processing instructions. The manufacturing tickets were kept in secure cabinets when not in use by the plan operators, and access to the production areas where the processes were performed was restricted.
The chemical reactions involved in the manufacture of bulk propoxyphene napsylate are precisely the same as those involved in the manufacture of bulk propoxyphene hydrochloride, from the first step through the production of propoxyphene *1014 base in the final step of the process. *98 The only differences in the manufacture of the two salts are the agents and the manners of acidification of the propoxyphene base used in the last reactions to produce the salts.
The chemical manufacturing processes used in the manufacture of propoxyphene napsylate were developed in the chemical pilot plant of Lilly Research Laboratories during the period 1960 through 1963, soon after the discovery of propoxyphene napsylate. The napsylate patent, like the propoxyphene patent, was not a process patent, but rather covered the chemical substance itself. Accordingly, petitioner relied on secrecy to preserve the value of the manufacturing know-how involved in the manufacture of propoxyphene napsylate.
2. Pharmaceutical Manufacture The last phase in the manufacture of Darvon products is the phase in which the bulk material, propoxyphene hydrochloride, is made into the pharmaceutical product, Darvon (and its various formulations).
Pharmaceutical manufacturing is primarily a mixing operation and rarely involves sophisticated chemical processes. The critical aspect of pharmaceutical manufacturing is the quality control and attention to detail necessary to perform each step accurately so that *99 the final product is precisely what it is intended to be and conforms to the FDA-approved New Drug Application (hereinafter NDA) 8 for that product.
The manufacturing know-how necessary for the pharmaceutical manufacture of Darvon products was developed by petitioner during the years 1957 through 1966. In general, the processes and techniques so used by petitioner during those years were standard in the pharmaceutical industry. During the early 1960's, however, petitioner developed a method allowing it to improve its formulations of Darvon products containing aspirin. In the presence of moisture, propoxyphene hydrochloride causes aspirin to decompose and to form acetic acid and free salicylic acid. The FDA has established limits on the level of free salicylic acid, a highly irritating substance, allowed in products containing aspirin. Moreover, the presence of acetic acid in those products causes them to have the *1015 odor of vinegar. To prevent the decomposition of aspirin, petitioner developed a method whereby the propoxyphene hydrochloride was formed into a coated pellet, called a sphercote, which, when placed in a capsule *100 with aspirin, prevented the interaction of the propoxyphene hydrochloride and the aspirin. Petitioner also developed a mechanical means of inspecting every capsule to insure that every capsule contained one, and only one, pellet of propoxyphene hydrochloride.
The pharmaceutical manufacturing of Darvon-N products is generally the same as that for Darvon products. Their only difference is that Darvon-N products are primarily in tablet, rather than capsule, form.
E. Foreign Manufacture of Propoxyphene Products
Propoxyphene products have never been patented in any foreign country. However, since 1963, petitioner and Lilly Industries Ltd. (hereinafter Limited), a wholly owned United Kingdom subsidiary of petitioner, have made available to each other patents, manufacturing know-how, and other scientific and technical data pursuant to a cross license agreement entered into by them on January 1, 1965. In the cross license agreement, petitioner granted to Limited the exclusive license to make, use, and sell petitioner's products in the United Kingdom. Pursuant to that license, Limited manufactured the bulk chemicals propoxyphene hydrochloride and propoxyphene napsylate and sold propoxyphene *101 hydrochloride and propoxyphene napsylate final dosage form products in the United Kingdom through 1973.
IV. Historical Development of the Puerto Rican Operations of Petitioner and Lilly P.R .
A. Puerto Rico's "Operation Bootstrap "
In the 1940's, an economic development program began in Puerto Rico that later became known as "Operation Bootstrap." At first the program concentrated on land reform, public services, and Government ventures into industry. Later, its emphasis shifted to stimulating private investment. Under the Puerto Rican Industrial Incentive Act of 1954, eligible companies were entitled to a 10-year tax exemption from *1016 Puerto Rican income taxes measured from the start of their manufacturing operations in Puerto Rico. In addition, exemptions were provided from certain property taxes, license fees, and excise taxes. A company was eligible for those exemptions if its proposed Puerto Rican operation would manufacture in Puerto Rico a product not manufactured there before January 2, 1947, or if it met other limited criteria.
On June 13, 1963, the Puerto Rican Industrial Incentive Act of 1963 was enacted. The new act retained virtually all of the provisions of the 1954 Act *102 and added a number of new and more liberal provisions. One of the major new provisions provided for exemption periods of longer than 10 years if the Puerto Rican operations were conducted in a less developed area of Puerto Rico.
B. Petitioner's 1961-62 Study of Possible Puerto Rican Operations
From approximately June 1, 1961, through June 1, 1962, petitioner studied the possibility of establishing manufacturing operations in Puerto Rico. Petitioner had, at that time, received numerous visits from representatives of the Economic Development Administration of Puerto Rico attempting to interest petitioner in the economic development of that area. The visits included discussions of the tax advantages of doing business in Puerto Rico. As a result of those contacts, and in an effort to find out more about the possibilities of operating in Puerto Rico, petitioner designated a three-man team to visit Puerto Rico and to investigate the subject in detail.
During the 1961-62 study, petitioner considered the possible conduct in Puerto Rico of a wide range of manufacturing operations, including the manufacture of bulk chemicals, empty gelatin capsules, and finished capsule products. The study *103 included consideration of the possibility of performing the chemical manufacture of propoxyphene hydrochloride in Puerto Rico.
In January 1962, the project team traveled to Puerto Rico to investigate the establishment of a manufacturing plant there. During that trip, the project team had extensive discussions with the law firm of McConnell, Valdes & Kelley; the accounting firm of Ernst & Ernst; branch banks of First National City Bank and Chase Manhattan Bank, as well as two Puerto Rican *1017 banks, Banco Popular and Banco Ponce; the Economic Development Administration of Puerto Rico; and personnel of the Puerto Rican pharmaceutical manufacturing operations of Parke, Davis & Co. and Baxter Laboratories, Inc.
After returning from Puerto Rico, the project team developed an economic analysis of the proposed Puerto Rican manufacturing operations. In a memorandum dated April 30, 1962, the team recommended that petitioner file an application for a Puerto Rican industrial tax exemption for the pharmaceutical manufacture of capsule products in general. Although petitioner decided not to proceed with an operation in Puerto Rico at that time, due to the anticipated length of time required to obtain *104 approval of an application for Puerto Rican tax exemption, it did decide to file an application for such an exemption. Petitioner filed its application for a Puerto Rican industrial tax exemption on June 20, 1962. The application was broadly drafted to cover the pharmaceutical manufacture of all petitioner's capsule products.
Petitioner's June 20, 1962, application for an industrial tax exemption was approved and the requested exemption was granted on May 29, 1963. The required commencement date of operations, May 29, 1964, was subsequently extended to May 29, 1965, and later to May 29, 1966.
C. Petitioner's Second Puerto Rican Study 1965-66 During 1964, petitioner initiated an exhaustive study project to develop an expansion program to meet adequately its projected 1975 requirements for dry pharmaceutical products. 9 Forecasts were prepared of product needs and the facilities necessary to meet those needs. Several alternatives were developed, including utilizing existing facilities with some additional construction as well as selecting a new plant site for current and future expansion. The presentation of the study to management in February 1965 precipitated a renewed interest *105 in the possibility of Puerto Rico being the site of expanded facilities, although the original study did not contain that suggestion.
*1018 Petitioner's primary purpose for considering construction of a manufacturing plant in 1965 was to provide additional capacity to meet its projected 1975 production requirements. Petitioner attempted to operate its chemical and pharmaceutical manufacturing facilities at about 80 percent of full capacity. Petitioner traditionally operated its chemical manufacturing facilities three 8-hour shifts per day, five days a week, and its pharmaceutical manufacturing facilities one 8-hour shift per day, five days a week, thereby allowing petitioner to accommodate sudden demands for full capacity resulting from epidemics or the introduction of a new product by working overtime on weekends. In 1964 and 1965, petitioner's chemical and pharmaceutical manufacturing facilities were operating at more than 80 percent of full capacity and were becoming overcrowded.
Petitioner's *106 need for additional manufacturing facilities continued throughout the period 1965 through 1973. As noted previously, Building T28 was built in 1965 at Tippecanoe Laboratories to relieve the overcrowding at that chemical manufacturing facility. Tippecanoe Laboratories again was expanded after 1965 to accommodate the transfer of chemical manufacturing operations to that facility from Indianapolis. In 1969, petitioner began construction of a new chemical manufacturing facility on a 684-acre site at Clinton, Indiana, which facility became operational in 1971. Petitioner's Kentucky Avenue facility, where all its pharmaceutical manufacturing operations for dry products were located, was especially overcrowded and the extent to which it could be expanded was limited. Therefore in 1973, petitioner began construction of a new manufacturing facility on a 160-acre site adjacent to its existing Kentucky Avenue facility.
Petitioner elected to locate the needed manufacturing operations in Puerto Rico for a variety of reasons. One reason for that decision was petitioner's desire to obtain the tax benefits provided by the Puerto Rican Industrial Incentive Act of 1963 and section 931 . In addition, *107 the establishment of manufacturing operations in Puerto Rico would geographically disperse petitioner's manufacturing facilities, which in 1965 were concentrated in Indianapolis and nearby communities in Indiana. During the 1960's, petitioner was concerned that its concentrated manufacturing facilities were overly exposed to *1019 the risks of natural and man-made (i.e., nuclear) disasters. The concentration of all capsule and dry products pharmaceutical manufacturing operations at the Kentucky Avenue plant in Indianapolis was of special concern. A disaster at that location would have severely affected petitioner's ability to supply products to a substantial market segment. The possibility of such a disaster became apparent in April 1965, when a tornado caused great damage to an area just north of Indianapolis.
Finally, the establishment of manufacturing operations in Puerto Rico would allow petitioner to isolate the manufacture of a major product in a separate facility, thereby eliminating the possibility of cross-contamination problems.
From February 1965 to August 1966, petitioner conducted a second study specifically focusing on the development of Puerto Rican manufacturing operations. *108 In March 1965, petitioner appointed a special project team to gather and evaluate information on the establishment and operation of a Puerto Rican manufacturing plant. The project team recognized that there were some disadvantages associated with a Puerto Rican operation. Puerto Rico's distance from the continental United States would create coordination and logistical problems in moving products to the market. There was concern with respect to the availability of a qualified labor force and the extent of training and development of employees that would be required. The team was also aware of the possibilities that natural disaster, political unrest, or labor strife would close the shipping lanes to Puerto Rico. Furthermore, a Puerto Rican operation would create additional governmental reporting requirements with their associated administrative expenses.
In view of the business objectives and the perceived disadvantages of operating in Puerto Rico, the project team recommended that a small number of large volume products should be selected for the Puerto Rican operation. Accordingly, the project team selected for further study Darvon and Ilosone Registered TM products, petitioner's *109 largest volume dry products at that time.
The initial proposal considered by the project team in 1965 was an updated version of the proposal considered by petitioner in 1962. That proposal contemplated the establishment of a facility in Puerto Rico to manufacture empty capsules and *1020 perform the pharmaceutical manufacture of all petitioner's Darvon and Ilosone capsule products for sale to petitioner. Under that proposal, the Puerto Rican operation would purchase its bulk chemicals from petitioner.
One of the significant problems the project team faced was the issue of intercompany pricing under section 482 . In 1965, the Internal Revenue Service (hereinafter the Service) had not issued, in either proposed or final form, detailed regulations under section 482 relating to the sale of goods between related parties. The project team for the 1962 study had also recognized the existence of the section 482 issue. Essentially, the only guidance available to the 1962 project team was the statutory language of section 482 , although it hoped that representatives of the Puerto Rican and U.S. Government would issue a set of ground rules relative to intercompany pricing prior to any actual decision *110 to construct facilities in Puerto Rico. Subsequent to the conclusion of the 1962 study and prior to the inception of the second study in 1965, the Service issued Technical Information Release 441 , later reprinted as Revenue Procedure 63-10 , which set forth guidelines for the application of section 482 to transactions between mainland parents and Puerto Rican affiliated corporations. While the members of the project team in 1965 were familiar with the revenue procedure, they found that it did not eliminate all the uncertainty with respect to intercompany pricing.
On or about March 30, 1965, shortly after its formation, the project team obtained the assistance of petitioner's outside tax counsel, the law firm of Baker McKenzie & Hightower, and the accounting firm, Ernst & Ernst. In April 1965, at the suggestion of the outside tax counsel, the project team considered two variations of the initial proposal. First, the team considered the possible sale of the products manufactured in Puerto Rico direct to unrelated wholesalers in the United States rather than to petitioner for resale to such wholesalers. Second, the project team considered the possible manufacture of bulk chemicals *111 in Puerto Rico by the Puerto Rican operation rather than in Indiana by petitioner. The two variations of the original proposal gave the project team the following four alternatives to analyze:
*1021 (a) Chemical manufacture in Indiana, pharmaceutical manufacture in Puerto Rico, and sales to petitioner (i.e., the original proposal);
(b) Chemical manufacture in Indiana, pharmaceutical manufacture in Puerto Rico, and sales direct to wholesalers;
(c) Chemical and pharmaceutical manufacture in Puerto Rico and sales to petitioner; and
(d) Chemical and pharmaceutical manufacture in Puerto Rico and sales direct to wholesalers.
For the purpose of analyzing these alternatives, the team assumed that the Puerto Rican operation would be a wholly owned subsidiary corporation, and that it would manufacture Darvon products only.
Members of the project team discussed the four alternatives with petitioner's outside tax counsel. Alternatives (c) and (d) were viewed as the most desirable because the Puerto Rican corporation would be using the propoxyphene patent in its chemical manufacturing operations, and the patent thus could be transferred to it in a nonrecognition transfer under section 351 . Because the *112 Puerto Rican corporation would own the patent, the outside tax counsel opined that it would be deemed to have earned the income attributable to the patent. Also, because the Puerto Rican corporation would own the patent and would manufacture the basic chemicals, the issue of the appropriate intercompany prices for bulk chemicals sold by petitioner to the Puerto Rican corporation would be eliminated. Furthermore, the transfer of the patent and chemical process to Puerto Rico would effect a complete separation of the manufacturing and marketing functions with respect to Darvon products, thus petitioner would be performing a pure marketing function and an appropriate transfer price from Puerto Rico could be determined by reference to third-party evidence of the value of that marketing function.
In comparing alternatives (c) and (d), the project team recognized that both involved the transfer of the propoxyphene patent to a corporation operating outside the United States. The team did not consider that a disadvantage, however, because the patent: (1) Would be owned by a wholly owned subsidiary corporation; (2) would be physically in the United States; (3) could be recovered by collapsing *113 the subsidiary and merging it into petitioner; and (4) would not be subject to *1022 expropriation. Although alternative (d) (sales direct to wholesalers) would enable the Puerto Rican operation to earn the larger amount of net income and would provide the greater number of arm's-length dealings with petitioner, the fact that wholesalers would have to deal with a second organization (the Puerto Rican operation) whenever they ordered, received, and paid for products manufactured in Puerto Rico was considered a major disadvantage and caused the project team to reject that alternative.
At a special meeting of petitioner's board of directors on May 5, 1965, the project team presented its proposal to establish facilities in Puerto Rico for the manufacture of chemicals and empty capsules and the pharmaceutical manufacture of capsule products. After discussion, the board approved the following resolutions:
Resolved, That the establishment by Eli Lilly and Company (or a subsidiary or subsidiaries thereof) in the Commonwealth of Puerto Rico of facilities for the manufacture of chemicals and capsules and the filling and finishing of Pulvules Registered TM with an investment of up to approximately *114 six and one-half million dollars ($ 6,500,000), be, and it is hereby, approved in principle.
Further Resolves, That the proper officers of the Company be, and they hereby are, authorized for and on behalf of the Company:
a. to make such investigations, formulate such plans and to make such commitments as they may deem necessary to expedite the establishment of such facilities.
b. to negotiate, with the Commonwealth of Puerto Rico, its agencies, subdivisions or municipalities in order to obtain necessary authorizations and a grant or grants of tax exemption pursuant to the Industrial Incentive Act of 1963, and to execute any and all documents that in their opinion may be necessary or proper for such purposes.
c. to enter into lease(s) of facilities for use in the manufacture of products for a term not exceeding three (3) years.
d. to execute option(s) to purchase real estate in the Commonwealth of Puerto Rico.
Further Resolved, That nothing contained in the foregoing resolutions shall be deemed to authorize or approve the appropriation of funds for capital expenditures.
Shortly after the special board of directors meeting on May 5, 1965, representatives of petitioner traveled to Puerto Rico *115 to investigate possible sites for the construction of manufacturing facilities there. At that time, petitioner planned first to establish pharmaceutical manufacturing operations in a *1023 leased facility in order to gain experience in operating a Puerto Rican plant and to begin taking advantage of the potential tax savings. Petitioner next intended to establish empty capsule manufacturing and pharmaceutical manufacturing on a permanent site owned by the Puerto Rican operation. To those ends, during May 1965, petitioner selected leased facilities in Hato Rey, Puerto Rico, and a permanent plant site in Carolina, Puerto Rico. Petitioner tentatively planned as its third step to establish chemical manufacturing facilities in a permanent site owned by the Puerto Rican operation; however, no definite decision was made to transfer all or part of the chemical manufacture of Darvon, or the propoxyphene patent, to the Puerto Rican operation at that time.
On May 25, 1965, members of the project team met with petitioner's outside tax advisers and discussed three aspects of the Puerto Rican operation: corporate structure, financial structure, and intercompany pricing. At that meeting, it was decided *116 that the Puerto Rican operation would be conducted through a new, wholly owned Indiana subsidiary of petitioner that would qualify as a possessions corporation under section 931 . It was also decided that the subsidiary corporation would be sufficiently capitalized so that it could borrow funds to maintain its operations until it was in full production without the necessity of a guarantee from petitioner. Although the issue of intercompany pricing was discussed extensively at that meeting, final intercompany pricing decisions were deferred until a decision was made with respect to the extent of the chemical manufacturing operations that would be conducted by the subsidiary.
Petitioner organized Lilly P.R. on June 9, 1965, as a wholly owned subsidiary corporation. On August 3, 1965, members of the project team and other employees of petitioner met to discuss the scope of Lilly P.R.'s chemical manufacturing operations and the related intercompany pricing issues. At that meeting it was informally decided that at least the last step in the propoxyphene hydrochloride manufacturing process (step 6 (propoxyphene hydrochloride)) and the propoxyphene patent should be transferred to Puerto *117 Rico. There was still a question, however, with respect to whether step 1 *1024 (propiophenone), and to a lesser extent steps 2 through 5, should be transferred to Puerto Rico.
At a meeting on August 19, 1965, members of the project team and other employees of petitioner concluded that the entire chemical manufacturing process for propoxyphene hydrochloride should be transferred to Puerto Rico. That decision enabled the participants at the meeting to reach final decisions with respect to the transfer pricing of Lilly P.R.'s products. The participants decided that the Darvon products sold by Lilly P.R. to petitioner should be priced on a basis that would permit petitioner to recover its selling and distribution expenses plus a profit of 90 to 100 percent of those expenses, which was achieved by discounting petitioner's net wholesale prices for Darvon products by approximately 27.5 to 35 percent. The participants also decided that Lilly P.R. and petitioner should enter into a sales contract that would be reviewed periodically and would provide for rebates from Lilly P.R. to petitioner for sales of Darvon products by petitioner to the U.S. Government.
Petitioner's project team considered *118 the profit margins of other companies selling finished pharmaceuticals in an attempt to determine an appropriate transfer price for Lilly P.R.'s products. The project team ideally was looking for a company that purchased finished pharmaceutical products from unrelated manufacturers and marketed such products to unrelated customers. The only company performing those functions that petitioner could identify was Marion Laboratories, Inc. The prospectus of that company indicated that its operating income expressed as a percentage of its operating expenses ranged from 5 to 53 percent for the years 1961 through 1965. The project team also examined the operating income to operating expense ratios of petitioner's international affiliates, which purchased finished pharmaceutical products and sold those products to unrelated customers. The ratios for those affiliates ranged from 65 percent to 108 percent during the years 1961 through 1964. 10 Based on that information, the project team concluded that petitioner should earn operating income on its sales of Darvon products purchased *1025 from Lilly P.R. equal to 90 to 100 percent of its operating expenses related to the marketing of Darvon *119 products.
The project team recognized that, under its three-step plan for commencing manufacturing operations in Puerto Rico, 11 *120 Lilly P.R. would not begin full manufacturing operations in Puerto Rico immediately, and petitioner would have to sell propoxyphene hydrochloride and other raw materials to Lilly P.R. while its permanent facilities were being constructed. Therefore, the team decided that Lilly P.R. should pay petitioner a price equal to petitioner's standard cost of manufacture, plus 100 percent. The 100-percent markup was chosen to provide petitioner the same markup over costs as it would receive for its marketing functions.
The project team also recognized that petitioner would be providing technical assistance to Lilly P.R. during the transition period while Lilly P.R.'s operations were being established. In June 1965, petitioner had established new procedures for the regular reporting of time spent by petitioner's personnel on Lilly P.R. projects and travel to Puerto Rico on behalf of Lilly P.R., so that the costs of those activities could be charged to Lilly P.R. At the meeting on August 19, 1965, the project team concluded that Lilly P.R. and petitioner should execute a technical assistance agreement pursuant to which Lilly P.R. would reimburse petitioner for its direct costs of providing such assistance.
V. Lilly P.R.'s Puerto Rican Tax Exemptions As stated previously with respect to petitioner's first Puerto Rican study, an industrial tax exemption was granted by the Commonwealth of Puerto Rico to petitioner on May 29, 1963, covering the pharmaceutical manufacture of capsule products. The tax exemption grant was transferred from petitioner to Lilly P.R. effective as of December 14, 1965. The period of that exemption was *121 10 years, commencing on April 1, 1966.
*1026 The May 1963 tax exemption grant was the first of six such grants under which Lilly P.R. conducted manufacturing operations in Puerto Rico during the years 1966 through 1973. The second industrial tax exemption, covering the manufacture of empty capsules, was granted to petitioner on August 5, 1965, pursuant to an application filed by petitioner on May 13, 1965. That exemption grant was transferred from petitioner to Lilly P.R. effective as of December 24, 1965. The period of the exemption was 10 years, commencing on January 1, 1968.
A Puerto Rican industrial tax exemption covering the chemical manufacture of propoxyphene hydrochloride and certain other chemicals was granted to Lilly P.R. on October 14, 1966, pursuant to an application filed by Lilly P.R. on March 15, 1966. The period of that exemption was 12 years, commencing on January 1, 1967.
A Puerto Rican industrial tax exemption covering the pharmaceutical manufacture of tablet products was granted to Lilly P.R. on October 17, 1969, pursuant to an application filed by Lilly P.R. on August 15, 1968. The period of the exemption was 10 years, commencing on June 1, 1969. On March 5, 1973, *122 the exemption was amended to include the production of plastic bottles and containers.
A Puerto Rican tax exemption covering the pharmaceutical manufacture of liquid products (i.e., suspensions) was granted to Lilly P.R. on September 17, 1969, pursuant to an application filed by Lilly P.R. on August 15, 1968. The period of that exemption was 10 years, commencing on February 1, 1970.
A Puerto Rican industrial tax exemption covering the chemical manufacture of propoxyphene napsylate and other salts of propoxyphene was granted to Lilly P.R. on October 17, 1969, pursuant to an application filed by Lilly P.R. on August 16, 1968. The period of that exemption was 15 years, commencing on January 1, 1970.
In accordance with the terms of the six Puerto Rican industrial tax exemption grants mentioned above, Lilly P.R. during the years 1966 through 1973 was exempt from Puerto Rican income tax on its qualified income (i.e., income from manufacturing activities), municipal, and commonwealth taxes on real and personal property, license fees, and excise and other municipal taxes. Lilly P.R.'s qualified income included *1027 all income generated by sales of Darvon and Darvon-N products to petitioner.
VI. *123 Background and Documents Concerning Lilly P.R .
A. Organization of Lilly P.R. and Initial Capitalization
As stated earlier, Lilly P.R. was organized under Indiana law as a wholly owned subsidiary of petitioner on June 9, 1965. Pursuant to the authorization of petitioner's executive committee, Lilly P.R. was initially capitalized with an investment of $ 1,000 on June 11, 1965, at which time 1,000 shares of Lilly P.R. common stock with no par value were issued to petitioner. By the end of 1965, petitioner had contributed a total of $ 500,000 cash to the capital of Lilly P.R.
In 1965, Lilly P.R. negotiated a $ 4.5 million line of credit with the San Juan branch of the Chase Manhattan Bank. Petitioner did not assist Lilly P.R. in those negotiations, nor did it guarantee repayment of any amounts loaned to Lilly P.R. under the line of credit. The purpose of the line of credit was to finance the operations of Lilly P.R. until it commenced the manufacture and sale of products to petitioner. During the years 1965 and 1966, Lilly P.R. borrowed from the Chase Manhattan Bank an aggregate amount of $ 1,650,000. Lilly P.R. repaid the loans in full by July 1966.
B. Technical Assistance Agreement
On *124 April 8, 1966, petitioner and Lilly P.R. executed an agreement entitled "Technical Assistance Agreement," which was effective from January 1, 1966, to December 31, 1975. The execution of that agreement was ratified by Lilly P.R.'s board of directors on April 28, 1966.
In article II of the agreement, petitioner stated that it would, so far as practicable without unreasonable interference with its own business:
make available [its] scientists, engineers, technicians, research experts, industrial designers and other technical personnel, including if necessary supervisory personnel, for the purpose of providing to [Lilly P.R.] training for its employees and other technical assistance and advice in connection with the manufacture of [Lilly P.R.] products, including the design, construction and operation of factories and other installations, and the installation, operation, and maintenance of the equipment therein.
*1028 Article II further provided that petitioner would make its manufacturing facilities available to Lilly P.R. for the training of Lilly P.R. personnel. For the purposes of that agreement, Lilly P.R. products included all products manufactured by Lilly P.R., or which it had a right *125 to manufacture, whether or not manufactured by Lilly P.R. in 1966.
Under article III of the agreement, Lilly P.R. obligated itself to pay petitioner the sum of: (a) The cost to petitioner attributable to the services of its personnel rendering technical assistance to Lilly P.R. in accordance with article II of the agreement, other than engineering services; (b) a technical assistance fee equal to 5 percent of the cost described in (a); and (c) petitioner's standard charge for engineering services performed on behalf of Lilly P.R.
C. Private Letter Ruling
On April 7, 1966, petitioner applied to the Service for a ruling that petitioner's proposed assignment to Lilly P.R., as a contribution to capital, of the patents and manufacturing know-how related to propoxyphene and certain other products would qualify for nonrecognition treatment under section 351 . The ruling application stated that, because of the current and anticipated demand for certain of its products, petitioner had found it necessary to expand its manufacturing facilities, and that its present plans were to establish full-scale manufacturing facilities in Puerto Rico for Darvon, Darvon-N, and other products. The ruling application *126 notified the Service that during the construction of Lilly P.R.'s permanent manufacturing facilities, Lilly P.R. would purchase its requirements for bulk chemicals from petitioner, but that after such facilities were in operation, Lilly P.R. would manufacture the basic chemicals in Puerto Rico and would no longer purchase such chemicals from petitioner. The ruling application also advised the Service that Lilly P.R. would sell essentially all its finished products to petitioner. Attached to the ruling application were a form of agreement providing for the transfer of the patents and manufacturing know-how from petitioner to Lilly P.R. and a copy of the technical assistance agreement between petitioner and Lilly P.R.
In a letter dated July 20, 1966, petitioner supplied additional information to the Service with respect to its section 351 *1029 ruling request and requested a ruling on the source of the income that would be generated by Lilly P.R.'s sales to customers in the United States. In that letter, petitioner described the business reasons for the transfer of patent rights and manufacturing know-how as follows:
The fundamental business reasons for the transfer of Eli Lilly Patent Rights *127 and Eli Lilly Technology to [Lilly P.R.] is that [petitioner] has decided to vest in [Lilly P.R.] the complete responsibility for the manufacture of the subject products. Since [Lilly P.R.] will have the complete responsibility for manufacturing the subject products it should have the complete right to do so under the Eli Lilly Patent Rights and Eli Lilly Technology. Thus, the business substance which motivates the transfer of rights to [Lilly P.R.] is the fact that these rights will be used exclusively by [Lilly P.R.].
In addition, as mentioned in the request for ruling, the formation of [Lilly P.R.] and the location of manufacturing facilities in Puerto Rico was prompted by [petitioner's] need for additional manufacturing facilities. It should be noted that [petitioner] currently has under active consideration further expansion of its manufacturing facilities in other areas in the United States. The transfer of complete responsibility for the manufacture of the subject products to [Lilly P.R.] will not in any way result in a reduction in the facilities now employed by [petitioner] in the United States. The [Lilly P.R.] facilities will clearly be an expansion of the manufacturing *128 facilities now available to manufacture [petitioner's] products. In this sense, the business motivation was clearly to provide additional manufacturing facilities for [petitioner's] products.
As support for the source of income ruling request, petitioner submitted with that letter the proposed terms of sale for Lilly P.R. sales to petitioner and other U.S. customers.
By a letter dated September 16, 1966, petitioner submitted additional information to the Service regarding the issue of whether the secret processes to be transferred to Lilly P.R. constituted property within the meaning of section 351 . Attached to that letter was a memorandum prepared by petitioner's technical personnel which described in detail the secret processes to be transferred to Lilly P.R.
On December 5, 1966, the Service issued the following private letter ruling to petitioner:
This is in reply to a request for ruling with respect to the Federal income tax consequences of a proposed transaction. Information was submitted in letters dated April 7, July 20, and September 16, 1966. The pertinent facts may be summarized as set forth below.
*1030 Eli Lilly and Company ("Lilly"), account number 35-0470950, is an Indiana *129 corporation engaged in the manufacture and sale of pharmaceuticals and related products and agricultural and industrial chemical products.
Due to current and anticipated demand for certain of its drugs, Lilly finds it necessary to establish a plant in Puerto Rico to expand the manufacturing capability for these products. The operation in Puerto Rico will be conducted by Eli Lilly and Company, Inc. ("P.R."), account number 66-0262012, as a wholly owned subsidiary of Lilly. For its contribution of $ 500,000, Lilly was issued 1,000 shares of no par value common stock of P.R. Additional capital for the purchase of land and the construction of plants will be raised by P.R. by borrowing on its own credit.
P.R. will manufacture Darvon, 12 Dymelor, Valmid and Ultran, which are the trademarks for four of the products presently manufactured and sold in the United States by Lilly. A ten-year tax exemption has been granted in Puerto Rico for the pharmaceutical formulation of two of these products and application will be made for such exemption for the other two drugs.
Lilly proposes to transfer to P.R. as a contribution to capital all right, title and interest in and to U.S. Patents 2,728,779 , *130 2,812,363 and 3,065,261 13 *134 and U.S. patent application 25,209 (relating to Darvon, Dymelor, Ultran and Valmid). In addition Lilly will grant and assign to P.R. the exclusive and perpetual right to use the existing technical information and manufacturing secrets and processes relating to the manufacture and formulation of these products. By these transfers, Lilly will convey to P.R. the exclusive right to make, use and sell under the patents and technical information and to license others to use such patents and technical information upon terms and conditions as P.R. may decide.
The patents to be transferred, except for Ultran, reveal the chemical reactions employed but do not disclose certain steps or the processes utilized in their manufacture in commercial quantities. These processes, which could generally be patented, are maintained as a secret by Lilly and cannot be learned by an analysis of the finished product. They relate to such aspects of manufacture as the solvent employed, the temperature and time duration of certain steps, the use of dangerous reagents in large quantities, the substitution of less expensive chemicals, and methods of recovering certain costly chemicals *131 from the process. The processes employed in the manufacture of Ultran are completely embodied in its patent.
Lilly will transfer to P.R. the technical reports on the processes. However, the manufacture of certain of the products is so complex that Lilly does not believe that a written description will be sufficient to accomplish the desired results. Lilly has therefore transferred to P.R., as a full-time employee, the head of one of its chemical manufacturing plants who was involved as a trouble shooter in these processes. In addition, Lilly has entered into an agreement with P.R. on April 8, 1966, under which Lilly will assist P.R. in the establishment of manufacturing facilities in Puerto Rico and render technical assistance, to the extent requested, in connection with the manufacture of the products. P.R. will reimburse Lilly for all costs incurred *1031 plus five percent and will pay for engineering services on the basis of Lilly's standard charges for such services.
P.R. will manufacture the products in Puerto Rico. Other than what may be sold in Puerto Rico to related and unrelated parties, the products will be sold to Lilly in Puerto Rico for trans-shipment to the United States *132 and resale by Lilly in the ordinary course of its business. The sales by P.R. will be in accordance with a statement of conditions of sale which accompanied the request for ruling and is incorporated in this ruling letter by reference.
Lilly does not intend to cause P.R. to sell or license any of the patent rights or technology to third parties. Lilly intends to operate P.R. as a subsidiary and has no intention of selling or otherwise disposing of the stock of P.R.
Based solely on the information submitted, it is held as follows:
(1) No gain or loss will be recognized to Lilly upon the transfer to P.R. as a contribution to capital of all substantial rights to the patents, patent application, secret processes and technology relating to the manufacture of Darvon, Dymelor, Ultran and Valmid ( section 351 ).
(2) The basis of the stock of P.R. in the hands of Lilly will include the adjusted basis of the property transferred (section 358(a)(1)).
(3) Based on the assumption that P.R. will be established and operated in accordance with the above representations, and that the sale of its products will be made in the manner indicated, the gross income realized by P.R. from the manufacture and sale *133 of pharmaceutical products to Lilly and other United States purchasers will constitute gross income from sources within a possession of the United States within the meaning of section 931(a)(1) of the Code.
No opinion is expressed as to the possible application of section 482 in the event it is subsequently determined that the amounts to be paid by P.R. for the technical assistance to be provided by Lilly does not represent adequate consideration for such assistance or as to whether part of the stock of P.R. was, in fact, received by Lilly for such assistance.
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.
A copy of this ruling should be attached to the Federal income tax returns of the taxpayers involved for the taxable year in which the transaction is consummated.
D. Assignment of Patents and Manufacturing Know-How
On December 5, 1966, in accordance with the private letter ruling issued to petitioner on that date, petitioner and Lilly P.R. entered into an agreement entitled "Assignment of Patents and Related Technical Data." That agreement provided as follows:
This Agreement, made the 5th day of December, 1966, by and between ELI LILLY AND COMPANY, a corporation organized and existing under *1032 and by virtue of the laws of the State of Indiana, with offices at 740 South Alabama Street, Indianapolis, Indiana (hereinafter referred to as "ELI LILLY"), and ELI LILLY AND COMPANY, INC., a corporation organized and existing under and by virtue of the laws of the State of Indiana, with offices at 301 East McCarty Street, Indianapolis, Indiana (hereinafter referred to as "P.R."),
Witnesseth:
Whereas, ELI LILLY is engaged in the business of manufacturing and selling pharmaceutical and biological products, and
Whereas, ELI LILLY in the course of its operations in the United States has acquired certain technical data, consisting principally of reports, drawings, specifications, blueprints, written descriptions of manufacturing *135 processes, and production information with respect to the manufacture of its Darvon Registered TM product line and related product lines, including combinations, and
Whereas, ELI LILLY has obtained two United States patents relating to its Darvon Registered TM product line, and
Whereas, ELI LILLY is willing to grant P.R. the exclusive right to use such technical data in conjunction with an assignment of such patents, and
Whereas, P.R. has been formed to conduct the manufacture of the Darvon Registered TM line of products for sale in the United States market, and
Whereas, P.R. desires to acquire said patents and technical data from ELI LILLY as a contribution to its share capital:
Now Therefore
In consideration of the mutual promises and covenants herein contained, the receipt and sufficiency of which are hereby acknowledged, it is understood and agreed by and between the parties as follows:
Article I
ELI LILLY hereby assigns to P.R. all right, title and interest in and to U.S. Patents 2,728,779 [the propoxyphene patent] and 3,065,261 [the napsylate patent]. By such grant, ELI LILLY conveys to P.R. the exclusive right to make, use and sell under said patents for their full lives and any extensions *136 or renewals thereof, and to license others to use the same upon such terms and conditions as P.R. may decide. ELI LILLY agrees to execute any documents and authorizations which may be legally required to enable the use of said patents by P.R.
Article II
Eli Lilly hereby assigns and grants to P.R. the exclusive and perpetual right to use and to license others to use the existing technical information and manufacturing secrets and processes of Eli Lilly relating to the manufacturing and formulation of its Darvon Registered TM product line within the United States and Puerto Rico. By said grant Eli Lilly conveys to P.R. the exclusive and perpetual rights to make, use and sell under said technical data and to license others to use the said technical data upon such terms and conditions as P.R. may decide.
Article III
In consideration for the rights, titles and interests set forth in Articles I and II above, P.R. agrees to receive said patents and related technical data as additional consideration for P.R.'s stock which has already been issued to Eli *1033 Lilly and to reflect in its corporate records said patents and technical data as contributions to share capital provided by Eli Lilly.
In Witness *137 Whereof, the parties hereto have caused this Agreement to be signed and sealed by their duly authorized officers at the places and on the dates set forth below.
Eli Lilly and Company
By: (S) Burton E. Beck
Executive Vice President
Signed and sealed at
Indianapolis, Indiana
this 5th day of December, 1966.
(S) C. H. Bradley, Jr.
Attest Eli Lilly and Company, Inc.
By: (S) W. B. Fortune
Chairman of the Board of Directors Signed and sealed at
Indianapolis, Indiana
this 5th day of December, 1966.
(S) Walter C. Taylor, Jr.
Attest The December 1966 Assignment of Patents and Related Technical Data contained the same terms as the form of assignment attached to petitioner's ruling request dated April 7, 1966. On December 19, 1966, petitioner's board of directors ratified the assignment to Lilly P.R., as a contribution to capital, of the propoxyphene patent, the napsylate patent, and the related manufacturing know-how. On the same date, Lilly P.R.'s board of directors ratified the acceptance of that assignment. The Assignment of Patents and Related Technical Data was recorded in the U.S. Patent Office on February 14, 1969.
In December 1966, immediately after the execution of the Assignment of Patent Rights *138 and Related Technical Data, petitioner ceased performance of step 6 of the propoxyphene hydrochloride manufacturing process. During the phase-in of Lilly P.R.'s chemical manufacturing facility in 1967, petitioner continued to produce dextro carbinol base (steps 1 through 5) *1034 for sale to Lilly P.R. Petitioner did not perform any of the steps in the production of propoxyphene hydrochloride after 1967.
E. Distribution Agreements
In accordance with the decisions made in 1965 and 1966 by petitioner's project team that the distribution of Lilly P.R.'s products would be made through petitioner's U.S. marketing organization, petitioner and Lilly P.R. entered into a "Distribution Agreement," effective as of January 1, 1966. In that agreement, Lilly P.R. appointed petitioner its nonexclusive distributor for the sale of Darvon products throughout the world. The distribution agreement provided that: (a) Petitioner would purchase all its requirements for Darvon products from Lilly P.R. and would promote those products through its marketing organization; (b) Lilly P.R.'s selling price to petitioner for each of the Darvon products was equal to petitioner's net wholesale price 14 for such product *139 less a 35-percent discount; (c) petitioner was entitled to charge back to Lilly P.R. (i.e., receive rebates from Lilly P.R.) 25 percent of the net wholesale prices of Darvon products sold by petitioner to U.S. Government agencies or exported by petitioner from the United States; (d) petitioner would make payments to Lilly P.R. within 180 days after the dates of Lilly P.R.'s invoices; (e) Lilly P.R. would supply reasonable quantities of Darvon products to petitioner at no charge for use by petitioner as samples; and (f) the agreement was for a term of 5 years, cancelable by either party upon 90 days' notice. The provisions of the distribution agreement regarding the place of sale and passage of title of the products were the same as the terms of sale submitted to the Service as support for petitioner's source of income ruling request in its letter to the Service dated July 20, 1966.
As of January 1, *140 1971, petitioner and Lilly P.R. entered into a new "Distribution Agreement," which superseded the 1966 distribution agreement. The terms and conditions of the 1971 agreement were the same as in the 1966 agreement, except that it provided that: (a) Lilly P.R.'s selling prices to petitioner for Darvon products were equal to petitioner's net wholesale *1035 prices less 45 percent; and (b) petitioner was entitled to chargebacks on Government and export sales of 15 percent of petitioner's net wholesale prices.
During the years 1971 through 1973, petitioner and Lilly P.R. executed 9 amendments to the 1971 distribution agreement. In general, those amendments added new products (e.g., Darvon-N) to be sold by Lilly P.R. to petitioner, modified the selling prices of products sold by Lilly P.R. to petitioner, 15 and provided that, effective January 1, 1973, Lilly P.R. would supply petitioner with Darvon and Darvon-N products for use as samples at Lilly P.R.'s cost. The selling prices as applicable to the years before us will be discussed at length in a later portion of our findings.
F. Joint Research Agreement
Although the technical assistance agreement between petitioner *141 and Lilly P.R. was sufficiently broad to cover research and development activities performed by petitioner for Lilly P.R., petitioner's research and development expenses related to propoxyphene products were not billed to Lilly P.R. pursuant to that agreement. In 1968, petitioner determined that those research and development expenses should be charged to Lilly P.R., so it entered into an agreement with Lilly P.R. entitled "Joint Research Agreement." The agreement was retroactively effective to January 1, 1967, and had a term of 7 years ending on December 31, 1973.
In pertinent part, the joint research agreement, provided as follows:
ARTICLE I.
RESEARCH COMMITMENTS
Section 1.1. [Petitioner] hereby agrees to undertake projects on behalf of [Lilly P.R.] and to arrange for clinical trials and all related activities in connection with the development and testing of the pharmaceutical and biological products.
Section 1.2. [Petitioner] agrees to undertake research, development and related activities under this Agreement only to the extent that --
(a) [Petitioner's] facilities and personnel permit, without interfering with [petitioner's] own research and development progress, the undertaking *142 of *1036 such activities without requiring any significant capital expenditures for alteration of [petitioner's] existing research and development facilities;
(b) [Petitioner] has complete control over the scheduling of any such activities within its research and development facilities;
(c) [Petitioner] does not become liable or responsible for the results of any such research and development activities.
ARTICLE II
CONSIDERATIONS
Section 2.1. The parties agree that [Lilly P.R.] shall have the exclusive and perpetual right to use any of the data developed by [petitioner] under the terms of this Agreement (including any items of a patentable nature and any patents which may issue thereon) within the United States and the Commonwealth of Puerto Rico and that [petitioner] will have the exclusive and perpetual right to use any of the data developed under the terms of this Agreement (including any items of a patentable nature and any patents which may issue thereon) in all areas of the world outside of the United States and the Commonwealth of Puerto Rico.
Section 2.2. [Lilly P.R.] agrees to pay [petitioner] the cost of any research, development and clinical trials undertaken by [petitioner] at the *143 request of [Lilly P.R.] under this Agreement.
Section 2.3. The cost of the research, development, and clinical trials undertaken by [petitioner] for [Lilly P.R.] shall be determined for the purpose of this Agreement in accordance with accounting practices which are consistent with sound accounting principles generally accepted in the United States. Without in any way limiting the foregoing, it is understood that such "research expenses" shall include the following expenses:
2.31. Salaries and wages of all employees working full time on such activities.
2.32. The cost of employee benefits pertaining to such employees.
2.33. Research grants.
2.34. The fees of research consultants.
2.35. The costs of biochemical analyses, chemical analyses, clinical expense, and all veterinary testing relating to such activities.
2.36. Cost of chemicals, accessories, glassware, and other supplies used directly in such activities.
2.37. Legal and other expenses spent in connection with obtaining and maintaining patents covered by this contract or in connection with patent interference proceedings related thereto.
2.38. Communication and travel costs, including stationery, postage, cable, phone, and travel expenses *144 of [petitioner's] personnel when such expenditures are in connection with [petitioner's] research, development, and clinical trials for [Lilly P.R.].
2.39. Depreciation or amortization of capital items used in such activities.
2.391. Any other expenses of occupancy and general administration appropriately attributable to such activities.
*1037 Section 2.4. [Petitioner] will submit to [Lilly P.R.] twice annually its statement of expenses incurred under the terms of this Agreement, and [Lilly P.R.] agrees to make payment thereof in United States dollars within thirty (30) days after receipt of each such statement.
G. Agreements Regarding Empty Capsules
In a license agreement dated January 1, 1968, petitioner granted Lilly P.R. a nonexclusive license to make, use, and sell empty capsules covered by two U.S. patents owned by petitioner. Under that license, Lilly P.R. was obligated to pay petitioner a royalty of 5 cents per 1,000 commercially acceptable empty capsules manufactured by Lilly P.R. and covered by either of the two patents. The agreement provided that it would terminate upon the expiration of both of the licensed patents or 30 days after either party gave written notice of termination *145 to the other party.
During the years 1970 through 1973, petitioner and Lilly P.R. entered into three agreements pursuant to which Lilly P.R. manufactured and sold empty capsules to petitioner.
VII. Lilly P.R.'s Manufacturing Activities
A. Temporary Leased Facility
In May 1965, and pursuant to the May 5, 1965, resolution of petitioner's board of directors approving the establishment of manufacturing operations in Puerto Rico, petitioner entered into a lease with Valencia Realty Corp. for 67,000 square feet of floor space on two floors in a new five-story building located in the Valencia section of San Juan, Puerto Rico. Petitioner's interest in that lease was assigned to Lilly P.R. in June 1965.
On August 5, 1965, a contract was executed between Lilly P.R. and a Puerto Rican construction company calling for the modification of the leased premises to accommodate the pharmaceutical manufacture of Lilly P.R.'s products. The first floor of the leased facility was used for office and warehouse space. The fifth floor was used to perform the pharmaceutical manufacture of Lilly P.R.'s products. In addition, Lilly P.R. installed air-conditioning, dehumidification, dust-collection, and power equipment *146 on the roof of the facility.
Pharmaceutical manufacturing operations became completely operational at the Valencia facility in January 1966. *1038 Prior to that time, pilot runs were made at that facility to test equipment and to train personnel.
During 1966, the pharmaceutical manufacture of Darvon products was performed both by Lilly P.R. in Puerto Rico and by petitioner in Indiana. By the end of 1966, petitioner had discontinued all pharmaceutical manufacturing operations for Darvon products with the exception of certain sample packaging operations. During the years 1967 through 1973, the entire pharmaceutical manufacturing process for Darvon and Darvon-N products was performed by Lilly P.R., except for certain sample packaging and, during the years 1968 through 1973, Identi-dose Registered TM 16 packaging of Darvon and Darvon-N products, which was performed or contracted by petitioner.
The Valencia site was designed to serve as a temporary facility while permanent facilities were under construction.
B. Carolina Facility
In May 1965, petitioner entered into an agreement *147 to purchase approximately 13 acres of land in an industrial park in Carolina, Puerto Rico, to be used as the site for Lilly P.R.'s permanent pharmaceutical manufacturing facilities. At a meeting on December 14, 1965, Lilly P.R.'s board of directors approved the acceptance of the assignment of that purchase agreement from petitioner.
In June 1965, Lilly P.R. entered into an agreement with a Puerto Rican architectural firm for the performance of architectural and engineering work in connection with the design and development of the Carolina plant. Construction of the Carolina facility started on September 1, 1966.
The manufacture of empty capsules was begun at the Carolina facility in October 1967. The period between October 1, 1967, and January 1, 1968, was a shakedown period but some marketable products were produced. As of January 1, 1968, Lilly P.R.'s investment in capsule manufacturing machinery and equipment was $ 1,499,739. At the time that empty capsule production was begun, approximately 92,000 square feet of the Carolina facility were completed, consisting of the common service building (the powerhouse), the warehouse, and the empty capsule manufacturing department.
*1039 Pharmaceutical *148 manufacturing operations were completely operational at the Carolina facility by May 15, 1968. At that time, the facility occupied approximately 175,000 square feet, divided functionally as follows: Square feet
Common services 19,000
Warehouse 40,000
Empty capsule manufacturing department 33,000
Office building 17,000
Capsule filling 50,000
Capsule finishing 16,000
Total 175,000
As of June 1, 1968, the total investment in pharmaceutical manufacturing operations at Carolina was $ 2,468,462, of which $ 568,327 represented direct production equipment and $ 1,900,135 represented supportive equipment. As of June 1, 1968, the total cost of the Carolina facility was $ 8,917,499, of which $ 531,276 was invested in land, $ 5,037,098 in buildings, and $ 3,349,125 in machinery and equipment. An additional $ 619,075 of machinery and equipment transferred from the Valencia operation was also used at the Carolina facility.
C. Mayaguez Facility At a meeting on January 20, 1966, Lilly P.R.'s board of directors authorized the officers of that company to select a plant site in Puerto Rico for Lilly P.R.'s chemical manufacturing facility and to develop plans and cost estimates for that facility. After the meeting, *149 Lilly P.R.'s officers began looking for sites for the proposed chemical manufacturing plant with the assistance of the Puerto Rican government. After negotiations with more than one government agency, Lilly P.R. obtained the necessary government approvals to build a plant at a site in Mayaguez, Puerto Rico, at the western end of the island. In June 1966, Lilly P.R. purchased a 25-acre site in Mayaguez.
Construction of the Mayaguez facility was started in August 1966, pursuant to contracts between Lilly P.R. and a Puerto Rican construction firm. The construction of the Mayaguez plant was completed in October 1967.
The performance of step 6 (propoxyphene hydrochloride) in the production of bulk propoxyphene hydrochloride was started *1040 at Lilly P.R.'s Mayaquez facility in December 1966, subsequent to the execution on December 5, 1966, of the Assignment of Patents and Related Technical Data. Lilly P.R. began production of step 1 in August 1967, step 2 in September 1967, and steps 3, 4, and 5 in October 1967.
In December 1966, when production of step 6 began, the Mayaquez facility occupied approximately 14,340 square feet as follows: Square feet
Building 1, office building 3,840
Building 2, warehouse 7,000
Building 3, manufacturing 3,500
Total 14,340
Upon *150 completion of the Mayaguez facility in October 1967, the following additional structures were utilized in the manufacturing operation: Square feet
Building 4, sewage plant 1,600
Building 5, fire pump house 900
Building 6, major manufacturing building 24,000
Building 7, warehouse 10,000
Tank farm consisting of eighteen 12,000 gallon tanks 30,000
Total 66,500
The total amount invested in the Mayaguez chemical facility as of October 1, 1967, was $ 6,192,257, of which $ 302,316 was invested in land, $ 2,708,028 in buildings, and $ 3,181,913 in machinery and equipment. During the years 1969 through 1973, the manufacturing capacity of both the Mayaguez and Carolina facilities of Lilly P.R. was substantially expanded. Construction of additional facilities for the manufacture of propoxyphene napsylate at Lilly P.R.'s Mayaguez facility began in 1969 and was completed in 1970 at a total cost of approximately $ 1 million. As of December 31, 1973, Lilly P.R.'s total investment in physical facilities was $ 26,404,782, of which $ 978,756 was invested in land, $ 13,945,669 in buildings, and $ 11,480,357 in machinery and equipment.
D. Personnel
1. Organization of Initial Work Force The initial management of Lilly *151 P.R. consisted of five former employees of petitioner who moved to Puerto Rico to become *1041 permanent employees of Lilly P.R. One of the principal assignments of that management team was to train the Puerto Rican work force of Lilly P.R. and to develop Puerto Rican employees capable of taking over the management of Lilly P.R.
Soon after the management team arrived in Puerto Rico, it began the process of interviewing and employing Puerto Ricans to staff the temporary facility at Valencia. The team worked closely with the Puerto Rican Employment Service, a government agency which screened all applications to determine which applicants were best qualified to meet the job descriptions supplied by Lilly P.R., and performed background checks and applicant health examinations. By January 1966, Lilly P.R. employed 56 Puerto Ricans; by January 1968, Lilly P.R. employed over 400 Puerto Ricans. The hiring of those employees was accomplished without petitioner's assistance. When Lilly P.R.'s pharmaceutical manufacturing operations were transferred from Valencia to Carolina in 1968, all the employees at the Valencia facility moved to the Carolina facility.
2. Training of Employees At the beginning *152 of Lilly P.R.'s operations in Valencia, small teams of petitioner's employees traveled to Puerto Rico, at the request of Lilly P.R., for 2 or 3 weeks at a time to assist in the training of the employees at that facility. The teams were small, less than 10 in number, because Lilly P.R.'s management team was experienced in production, and because Lilly P.R. rapidly developed a group of Puerto Rican employees who were capable of assisting in the training function.
The training of the work force at Lilly P.R.'s Mayaguez facility required more assistance from petitioner because the chemical manufacturing process for propoxyphene hydrochloride was complicated and dangerous, and because employees in the Mayaguez area generally were less fluent in English than those in the San Juan area. Consequently, 12 to 14 of petitioner's chemical manufacturing employees were residents in Mayaguez for a period of from 6 to 12 months to train Lilly P.R.'s Puerto Rican chemical manufacturing operators.
In 1968, because the work force at the Valencia facility had over 2 years' experience in the pharmaceutical manufacture of *1042 Lilly P.R.'s products, and because the entire work force moved from Valencia to the *153 Carolina facility in that year, Lilly P.R. did not require any great amount of assistance from petitioner in training its employees at the Carolina facility.
3. Board of Directors, Officers, and Management Committees During the years 1965 through 1973, Lilly P.R.'s board of directors consisted of from 9 to 11 individuals. Throughout that period, two of the directors were management employees, the general manager and treasurer, of Lilly P.R. living in Puerto Rico. The remaining members of Lilly P.R.'s board of directors were officers and/or employees of petitioner.
During the years 1965 through 1973, Lilly P.R. had an executive committee, which had 5 members through 1972 and 6 members in 1973. During the years 1971 through 1973, Lilly P.R. also had the following committees: operations, salary, budget, safety and housekeeping, and benefits and retirement.
During the years 1971 through 1973, Lilly P.R.'s general manager had authority to approve capital expenditures of less than $ 1,000; the operations committee had authority to approve capital expenditures of less than $ 5,000; the executive committee had authority to approve capital expenditures of less than $ 25,000; Lilly P.R.'s board *154 of directors had the authority to approve capital expenditures of between $ 25,000 and $ 50,000; and proposed capital expenditures in excess of $ 50,000 were submitted for approval to petitioner's executive committee or board of directors. The division of authority for the approval of capital expenditures was the same as that followed by every other domestic and foreign subsidiary of petitioner.
4. 1971-73 Lilly P.R. Personnel
During the years 1971, 1972, and 1973, Lilly P.R. had a total of 608, 612, and 651 employees, respectively. During that period, all employees below the management level were Puerto Rican.
During the years 1971, 1972, and 1973, Lilly P.R. had 22, 25, and 23 management employees, respectively. In 1971, 15 of those management employees were Puerto Ricans.
E. Manufacturing Activities 1971-73
1. Production Planning *1043 The planning and scheduling of Lilly P.R.'s manufacturing operations were conducted in Puerto Rico by employees of Lilly P.R. without the assistance of petitioner. Lilly P.R.'s production planning process involved the scheduling of raw material purchases and the scheduling of production on a day-to-day basis consistent with Lilly P.R.'s policy of keeping *155 a stable and fully occupied work force.
Petitioner's finished stock planning department in Indianapolis provided Lilly P.R. with annual projections of the quantities of each package size of each product that petitioner would purchase from Lilly P.R. during the coming year. 17
From the annual projections, Lilly P.R.'s production planning group at the Carolina facility prepared production schedules for the pharmaceutical manufacture of the finished products to be sold to petitioner, and determined the quantities of propoxyphene hydrochloride and propoxyphene napsylate necessary to manufacture those products. Based upon the production schedule, the empty capsule manufacturing manager produced a schedule for the manufacture of empty capsules. Also, materials-purchasing personnel determined whether and when to purchase raw materials for the empty capsule manufacturing operation based upon inventory levels of materials on hand.
The projections of annual requirements for propoxyphene hydrochloride and *156 propoxyphene napsylate prepared at Carolina were sent to the Mayaguez facility and used as the starting point for its production planning. Personnel at Mayaguez determined the quantities of intermediate chemicals necessary to produce the final chemicals and projected the amount of basic raw materials needed during the year. The purchasing department of Mayaguez issued purchase orders throughout the year based upon the projected requirements for raw materials.
2. Chemical Manufacturing at Mayaguez During the years 1971 through 1973, propoxyphene hydrochloride and propoxyphene napsylate were manufactured in bulk form at Lilly P.R.'s Mayaguez facility and transported to Lilly P.R.'s Carolina facility for use in the pharmaceutical *1044 manufacture of Darvon and Darvon-N products. The chemical manufacturing processes at the Mayaguez facility involved numerous continuous reactions, and as a result, that facility was generally operated 24 hours per day, 5 days per week. The manufacturing activities at Mayaguez were conducted according to a campaigning program. For example, a 2-week campaign might have been conducted to build up stock of propiophenone (step 1) which was then used during a *157 subsequent 2-week campaign to produce iso butyro phenone derivative (step 2).
Each of the steps in the manufacturing process was covered by a separate manufacturing ticket (manufacturing tickets are defined in section F under this heading, infra ), and generally was performed independently of the other steps. Although each step took only 1 to 3 days to complete, in the normal sequence of operations at Mayaguez, an entire series of campaigns from the beginning (step 1) to the end (step 6) took approximately 60 to 90 days to complete.
The chemical manufacturing processes performed by Lilly P.R. at the Mayaguez facility were complicated. Each of the 6 steps in the production of propoxyphene hydrochloride and propoxyphene napsylate was in itself a multistep process requiring the utilization of approximately 28 reaction tanks and the services of approximately 35 operators, working on a three-shift basis. The processes involved the use of highly corrosive and flammable chemicals, and as a result, Lilly P.R.'s operators wore acid goggles, air line respirators, and rubber gloves while handling those chemicals. Most of the chemical reactions involved in the processes had to be performed within *158 narrow ranges of variables such as temperature and quantity. For example, if too little heat was applied to the reaction of propionic anhydride and dextro carbinol base in the final step of producing propoxyphene hydrochloride, some of the dextro carbinol base would remain in the propoxyphene base as a contaminant. If too much heat was applied to that reaction, the propoxyphene base was decomposed. The operators were required to exercise judgment during the manufacturing processes, such as using a sight glass to determine whether separations of solutions had been made. Operators also were required to perform temperature and pH tests during the processes.
*1045 Lilly P.R.'s operators involved in the manufacturing processes at Mayaguez were all at least high school graduates. As a result of the complexity of the manufacturing processes, it generally took an operator 1 year to learn the skills necessary to perform properly all the procedures involved in only one of the 6 steps. It was not necessary, however, for each operator to be familiar with every step in order for the processes to function properly.
The intermediate chemicals produced at Mayaguez in steps 1 through 4 were analyzed *159 in the plant laboratory and subjected to as many as 8 quality control tests. Steps 5 and 6 were performed as one continuous process, during which samples were taken to the laboratory for analysis. The final product, propoxyphene hydrochloride or propoxyphene napsylate, was subjected to 28 quality control tests lasting a period of 2 days. After satisfactory completion of the quality control tests, the finished product was shipped to the Carolina facility in accordance with that facility's request for bulk chemicals.
3. Pharmaceutical Manufacturing at Carolina During 1971, 1972, and 1973, Lilly P.R.'s Carolina facility was engaged in the pharmaceutical manufacture of Darvon and Darvon-N products. Its manufacturing operations were divided into the manufacture of empty capsules, the formulation and encapsulation or tableting of the mixed material, 18 and the packaging and labeling of the finished products.
Lilly P.R.'s empty capsule manufacturing department operated 24 hours a day, 7 days a week, and employed approximately 65 to 80 people. The manufacturing process involved the *160 mixture of gelatin melts, using protocols (similar to manufacturing tickets, see pages 1046-1048) prepared and issued by Lilly P.R., and the actual production of the empty capsules on the capsule manufacturing machines. The empty capsules were tested throughout the manufacturing process to ensure the absence of physical defects and bacteria. The capsules passing those tests were stored for later use in Lilly P.R.'s pharmaceutical manufacturing operations.
The pharmaceutical manufacture of capsule products at Carolina entailed mixing the raw chemical materials and *1046 filling the empty capsules with the mixed, or formulated, materials. For the manufacture of tablet products, the dry chemical ingredients were mixed with a lubricant, compressed by machine into tablets, and coated with a colored material. The products were periodically tested and analyzed for physical defects, weight, and the amount of active ingredients.
The finished capsules and tablets were moved to the finishing department, where they were counted and filled into plastic bottles, 10 bottles at a time. The bottles were capped, labeled, and packaged in corrugated boxes for shipment to Indianapolis.
The entire pharmaceutical *161 manufacturing process for capsule products normally took approximately 1 month per lot. The filling operation, alone, took approximately 10 days per lot on a two-shift operation. Approximately 150 to 175 employees were involved in the production process, although at any one time, as few as 15 people might have been working on a particular lot. The pharmaceutical manufacture of tablet products, because of the additional steps of mixing the ingredients with liquids and coating, required approximately 1 1/2 to 2 months per lot to complete.
F. Manufacturing Tickets and Related Procedures
A manufacturing ticket is a document listing the step-by-step procedures for manufacturing one lot of a specific pharmaceutical product. A separate manufacturing ticket was issued by petitioner for each lot of each chemical intermediary and final bulk chemical product manufactured by Lilly P.R. at its Mayaguez facility and for each finished product manufactured at its Carolina facility. The manufacturing tickets, in essence, were oversized recipes listing the names and quantities of all of the ingredients to be used in the manufacturing process, the step-by-step actions required to combine them in perfect *162 order, and the specifications for the final product produced under the manufacturing ticket. They specified the checks and audits to be carried out by production workers and by quality control personnel, as well as the tests to be conducted at critical points by laboratory scientists. Manufacturing tickets for chemical manufacturing processes also indicated temperatures, pressures, and reaction times for the chemical reactions covered by those manufacturing tickets.
*1047 The manufacturing tickets were numbered to correspond with given lots of the product and were initialed by the operators of Lilly P.R. responsible for each step in the various manufacturing processes so that any problem that arose with respect to a lot could be traced back to the operators involved. FDA regulations required the use of documents such as manufacturing tickets to provide control and accountability in the manufacture of pharmaceutical products. The manufacturing ticket procedures used by petitioner and Lilly P.R. satisfied that FDA requirement, although manufacturing tickets were used by petitioner even before such documents were required by the FDA.
During the years 1966 through 1973, the manufacturing tickets *163 used by Lilly P.R. in its manufacturing processes were issued to Lilly P.R. by petitioner's ticket issuance department in Indianapolis, Indiana. The ticket issuance department was the custodian of the master formula for each product manufactured by petitioner and Lilly P.R. The ticket issuance department produced duplicates of the master formulas using a large 19 copying machine pursuant to instructions from petitioner's finished stock planning department that tickets were needed by Lilly P.R.'s Carolina facility or upon receiving requests for tickets from Lilly P.R.'s Mayaguez facility. The ticket issuance department assigned the lot number to each manufacturing ticket and produced tags or stickers called manufacturing tags which bore the lot number and were to be placed on containers to identify raw and work-in-process materials to that lot. The manufacturing tags, required by FDA regulations, were sent to Lilly P.R. along with the manufacturing tickets for the lot. After the manufacturing tickets were used by Lilly P.R. in its chemical and pharmaceutical manufacturing processes, they were returned to petitioner's ticket issuance department in Indianapolis for microfilming *164 and storage.
The manufacturing tickets used by Lilly P.R. for the production of Darvon products were essentially the same as those developed by petitioner prior to 1967 for use in its manufacture of those products. The manufacturing tickets for Darvon-N products were developed jointly by petitioner and *1048 Lilly P.R. The master manufacturing tickets for Darvon and Darvon-N products were modified from time to time, based upon recommendations by employees of Lilly P.R. Generally, those modifications were made to remedy a problem or implement improved manufacturing procedures developed by Lilly P.R.
During the years 1971 through 1973, Lilly P.R. personnel recommended approximately 55 modifications of the manufacturing tickets for Darvon and Darvon-N products, 2 of which were the subject of a supplemental NDA. (See pages 1067-1068.) All the manufacturing ticket modifications recommended were adopted, even though there were some comments by petitioner that resulted in further testing by Lilly P.R. prior to their adoption.
In addition to the manufacturing tickets, Lilly P.R., during the years in issue, *165 used master packaging orders issued by petitioner's ticket issuance department in Indianapolis. Those master packaging orders were used by Lilly P.R.'s Carolina facility to produce the packaging orders it used in the packaging of Darvon and Darvon-N products.
During the years 1971, 1972, and 1973, Lilly P.R. also used numerous written procedures (called protocols) that had been developed by Lilly P.R. to cover manufacturing and other activities that were not covered by manufacturing tickets or packaging orders. For example, the Mayaguez facility of Lilly P.R. developed protocols to cover the reworking of chemicals it produced that did not meet specifications, and the Carolina facility developed standard procedures for the preparation of gelatin solutions. Both the Mayaguez and Carolina facilities developed procedures that covered virtually every aspect of their operations, including administrative and financial functions. In this respect, Lilly P.R. had the use of numerous manuals prepared by petitioner in its manufacturing and other operations.
G. Raw Material Purchases
During the years 1968 through 1973, Lilly P.R.'s chemical and pharmaceutical manufacturing activities respectively *166 required the use of approximately 35 and 140 different raw materials. Lilly P.R.'s established policy was to purchase most of its raw materials from unrelated suppliers located in Puerto *1049 Rico; to purchase raw materials from unrelated suppliers located outside of Puerto Rico if Puerto Rican suppliers could not be located; and to purchase raw materials from petitioner only in rush situations, when it had trouble locating or obtaining materials from another source, or when petitioner was the only source. Lilly P.R.'s purchases of raw materials from third-party suppliers accounted for 80 percent, 81 percent, and 87 percent of its total raw material purchases in dollars for 1971, 1972, and 1973, respectively. The remainder of Lilly P.R.'s purchases of raw materials in those years were from petitioner. Among the purchases of materials from petitioner were all labels and literature used by Lilly P.R. for its Darvon and Darvon-N products.
Although petitioner provided Lilly P.R. with a list of suppliers of raw materials, Lilly P.R. was not required to purchase only from the suppliers on the list. During the years in issue, Lilly P.R. selected and evaluated its suppliers of raw materials *167 without petitioner's assistance.
H. Equipment Purchases
During the years 1965 through 1973, Lilly P.R. purchased equipment and machine parts either directly from third party suppliers or through petitioner. The procedures for those purchases are discussed in detail at pages 1099-1100.
Although equipment purchases by Lilly P.R. in excess of $ 50,000 were submitted to petitioner's executive committee or board of directors for approval, none of Lilly P.R.'s requests for authorization to purchase equipment was rejected during the years 1965 through 1973.
I. Technical Assistance During the years 1971, 1972, and 1973, Lilly P.R. received and paid for certain technical assistance from petitioner under the technical assistance agreement. Such assistance included the following:
a. Installation of new chemical and pharmaceutical manufacturing equipment, and instruction relative to the use of said equipment;
b. Maintenance and repair of chemical and pharmaceutical manufacturing equipment;
c. Managerial assistance relative to industrial health programs;
d. Expert industrial relations assistance;
e. Consultations with personnel relative to Lilly P.R.'s Credit Union;
*1050 f. Expert assistance relative to the *168 engineering and long term planning of manufacturing operations;
g. Expert assistance and coordination with public officials relative to waste treatment and the environmental impact of facilities;
h. Expert assistance relative to financial organization, payroll accounting and computerization of data;
i. Training in the areas of laboratory testing, accounting and managerial skills;
j. Assistance with problems in quality control laboratory;
k. Review of inventories and assistance in inventory planning;
l. Maintenance of Lilly P.R. aircraft;
m. Supervision of telephone communication system installation; and
n. Assistance in cafeteria and food service operations.
Petitioner provided technical assistance to Lilly P.R. only upon request. Lilly P.R. was free to and did retain unrelated outside consultants and advisers having mechanical, electrical, architectural, accounting, and legal expertise.
J. Quality Control
In the normal course of its operations, Lilly P.R. performed all required quality control tests on raw materials and in-process materials without the need for assistance from or coordination with petitioner. With one exception, Lilly P.R. also normally performed all quality control tests *169 on finished products. Lilly P.R.'s Mayaguez facility did not have the capability to perform toxicity tests on the final products, bulk propoxyphene hydrochloride and bulk propoxyphene napsylate. That testing was performed on samples of the products by petitioner's quality assurance department in Indianapolis, Indiana.
While petitioner did not routinely perform quality control tests on materials and products of Lilly P.R., it did perform a limited number of quality control tests at the request of Lilly P.R. For example, if Lilly P.R. encountered problems in performing a particular quality control test, it might have had petitioner perform the same test in order to compare results. The testing performed by petitioner took place in petitioner's quality control laboratories in Lilly Research Laboratories. Lilly P.R. reimbursed petitioner for the cost of the quality control testing performed at its request. In addition, petitioner performed quality control tests on raw materials that it manufactured or purchased for sale to Lilly P.R.
*1051 During the years in issue, petitioner provided to Lilly P.R. and all its other subsidiaries copies of petitioner's standard procedures for the performance *170 of quality control tests. Lilly P.R., however, developed some of its own procedures for testing raw materials. Also during the years in issue, Lilly P.R. sent copies of its assay reports on the final bulk products propoxyphene hydrochloride and propoxyphene napsylate produced by its Mayaguez facility and on certain raw materials and finished products produced by its Carolina facility to petitioner's quality assurance department in Indianapolis.
K. Sample and Identi-dose Packaging
During the years 1966 through 1972, under the terms of the distribution agreement, petitioner received from Lilly P.R. at no charge Darvon and Darvon-N capsules and tablets in bulk which petitioner packaged as samples. Commencing in 1973, petitioner purchased those samples at cost. During the period 1968 through 1973, petitioner purchased from Lilly P.R. at Lilly P.R.'s cost, Darvon and Darvon-N capsules and tablets in bulk which petitioner packaged in Identi-dose packages for resale to wholesalers.
VIII. Petitioner's Marketing Operations
A. Introduction

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4622015. Public record. Not legal advice.