G.D. Searle & Co. v. Commissioner

G.D. Searle & Co. and Subsidiaries, Petitioners v. Commissioner of Internal Revenue, Respondent

G.D. Searle & Co. v. Commissioner

Docket No. 12836-79

United States Tax Court

88 T.C. 252 ; 1987 U.S. Tax Ct. LEXIS 16 ; 88 T.C. No. 16 ;

February 4, 1987 ; As amended March 3, 1987 February 4, 1987 , Filed

*16 Decision will be entered under Rule 155 .

CONTENTS Page

Headnote 255

Introduction and Statement of Issues 256

Findings of Fact 257

I. History and Background of G.D. Searle & Co. 257

A. Petitioner 257

B. SCO 259

II. History and Background of SCO's Products 259

A. Aldactone and Aldactazide 259

B. Banthine and Pro-Banthine 261

C. Flagyl 262

D. Lomotil 264

E. Ovulen and Demulen 265

F. Serenace 267

III. Pharmaceutical Business of Petitioner and Its Subsidiaries 268

IV. Historical Development of the Puerto Rican Operations

of Petitioner and SCO 269

A. Tax Incentives for Puerto Rican Operations 269

B. Planning and Formation of SCO 270

C. SCO's Puerto Rican Tax Exemption Grants 273

D. Initiation of Pharmaceutical Manufacturing by SCO 274

E. Transfers of Intangible Property to SCO 276

F. Marketing Agreement 277

V. SCO's Manufacturing Activities 278

A. Acquisition of Chemical Manufacturing Facility at

Caguas 278

B. Construction of Pharmaceutical Manufacturing

Facilities at Caguas 279

C. Management and Personnel 280

D. Manufacturing and Related Activities 280

1. Products Manufactured and Sold 280

2. Production Planning and Scheduling 283

3. Inventory Control and Purchasing 284

4. Chemical Sourcing 286

5. Chemical Manufacturing 290

6. Pharmaceutical Manufacturing and Packaging 291

7. Production Tickets 293

8. Quality Control 295

9. Product Recalls 296

VI. Sale and Distribution of SCO's Products 298

A. Identity of SCO's Customers 298

B. Orders of SCO's Products 299

C. Billing Procedures 300

D. Other Distribution Procedures 301

VII. Petitioner's Marketing Operations 301

A. Introduction 301

B. Marketing of SCO's Products 302

1. Sales Representation 302

2. Marketing and Sales Administration 305

3. SCO's Marketing Fee Payments to Petitioner 305

4. SCO's Other Marketing Expenses 306

VIII. Research and Development Activities 307

A. Introduction 307

B. Research and Development Facilities 309

1. Petitioner's Facilities 309

2. SCO's Facilities 311

C. Regulatory Requirements 312

D. Petitioner's Regulatory Affairs Services Related to

SCO's Products 313

E. Other Research and Development Activities Related

to SCO's Products 318

1. Petitioner's Activities 318

2. SCO's Activities 319

F. Research and Development of New Pharmaceutical

Products 319

1. Aspertame 320

2. Norpace 321

3. Depepsen 322

4. Cu-7 322

G. Petitioner's Research and Development of Synthetic

Steroid Chemicals 323

H. SCO's Payments for Research and Development 323

IX. Regulatory Oversight and Legal Matters 324

A. Introduction 324

B. 1975 FDA Investigation 325

C. Product Liability Insurance 328

D. Pending Lawsuits 329

X. Accounting and Administration 331

A. SCO's Finance and Accounting Department 331

B. Petitioner's Information Systems Department 331

C. Payment of Administrative Services 331

XI. Financial Results of Petitioner's and SCO's Operations 332

A. Petitioner's Acquisitions 332

B. Sales Statistics 333

C. SCO's Operations 336

D. Investment of SCO's Funds 337

E. Petitioner's Operations 338

XII. Respondent's Proposed Adjustments 338

A. Notice of Deficiency 338

B. Amendment to Answer 339

Opinion 340

Introduction 340

Issue 1. Ownership of Intangibles for Section 482 Purposes 341

A. Summary of the Facts 341

B. Background of Relevant Provisions 350

1. Tax Incentives for U.S. Corporations Operating in

Puerto Rico 350

a. Sections 931 and 936 350

b. Puerto Rican Tax Incentives 353

2. Nonrecognition Provision of Section 351 354

C. Section 482 and Its Interrelationship With Sections

351 and 931 356

1. Scope of Respondent's Authority Under Section

482 356

2. Section 482 Allocations Involving Nonrecognition

Transfers 359

3. Application of Section 482 363

Issue 2. Was Petitioner's Income Clearly Reflected During 1974

and 1975 367

*17 Petitioner and its subsidiaries engaged in the invention, development, manufacturing, marketing, and sale of pharmaceutical and other related products. SCO, a Delaware corporation, was organized on Jan. 13, 1969, as a wholly owned subsidiary of petitioner. It engaged in the manufacture and sale of ethical pharmaceutical products in Puerto Rico. SCO was organized for valid business reasons and to take advantage of the tax benefits of sec. 931, I.R.C. 1954 , and Puerto Rican tax exemptions. Five of petitioner's seven major product lines were selected for transfer to SCO pursuant to sec. 351, I.R.C. 1954 , nonrecognition transactions. During 1969-71, petitioner and SCO entered into six agreements providing for the transfer to SCO of petitioner's entire right, title, and interest in certain intangible property (patents, technical data, licenses, copyrights, and trademarks) relating to SCO's products.

During the taxable years in issue, 1974 and 1975, petitioner provided marketing, and sales promotion services to SCO based on a marketing agreement entered into on Sept. 1, 1970, and was paid a fee computed on the basis of 25 percent of SCO's net U.S. sales. During those years, approximately *18 97 percent of the sales of SCO's products were made to unrelated customers. Petitioner also assisted SCO in packaging samples and in procuring certain raw materials, printed package inserts, and some packaging components. Other raw materials, package inserts, and packaging components were purchased by SCO from unrelated venders. Petitioner also provided administrative and regulatory compliance services to SCO during the years in issue and was paid a fee equal to 3 percent of SCO's net U.S. sales.

In the notice of deficiency, respondent disregarded SCO's ownership of the intangibles and allocated, pursuant to sec. 482, I.R.C. 1954 , more than 92 percent of SCO's gross income to petitioner. Held , SCO's ownership of the income-producing intangibles cannot be disregarded and, therefore, respondent abused his discretion in allocating more than 92 percent of SCO's gross income to petitioner. Held, further : The transfer of the intangibles to SCO caused a distortion in petitioner's income during the taxable years in issue. Accordingly, an allocation is required in order clearly to reflect the income of petitioner.

Robert J. Cunningham, Michael Waris, Jr. , Joseph L. Andrus , *19 Julian D. Nihil, Kim E. Cook , and Jane Panethiere , for the petitioners.

Joel V. Williamson , Charles S. Triplett , and Joseph R. Goeke , for the respondent.

Wiles , Judge .

WILES

*256 Respondent determined deficiencies in petitioners' consolidated corporate Federal income tax as follows: Year Deficiency

1974 $ 29,157,111

1975 28,678,504

By amendment to his answer, respondent conceded that the amount of the alleged deficiency for the year 1974 should be reduced to $ 19,413,557. On May 6, 1982, this Court severed from the case all issues other than the propriety of respondent's allocations under section 482 1 of gross income and related business expense deductions from Searle & Co. (hereinafter SCO) to petitioner G.D. Searle & Co. (hereinafter petitioner). 2 In the notice of deficiency, timely mailed on June 8, 1979, respondent allocated to petitioner from SCO the following amounts of gross income and related business expense deductions: *257 1974 1975

Gross income $ 92,718,000 $ 110,314,000

Related business expense deductions 38,980,000 46,678,000

Net income 53,738,000 63,636,000

These gross income adjustments determined by *20 respondent represented an allocation to petitioner of more than 92 percent of SCO's gross income from operations in those years. SCO was allowed to retain only an amount equal to its manufacturing costs plus 30 percent of such costs.

These allocations present the following questions for our consideration:

(1) Whether respondent may disregard petitioner's nonrecognition transfers of certain income producing intangibles to SCO, its wholly owned subsidiary *21 corporation, for the purposes of reallocating income derived from such intangibles to petitioner pursuant to section 482 ;

(2) If not, whether respondent's allocations of gross income and related business expense deductions from SCO to petitioner for the years 1974 and 1975 were arbitrary, capricious, or unreasonable;

(3) Whether an allocation under section 482 is required to clearly reflect petitioner's income. 3

FINDINGS OF FACT

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

*22 I. History and Background of G.D. Searle & Co .

A. Petitioner

Petitioner is a Delaware corporation whose principal place of business at the time of filing the petition herein was Skokie, Illinois. During the years 1974 and 1975, petitioner and its consolidated subsidiaries maintained their books and records on the accrual method of accounting with taxable *258 years beginning January 1 and ending December 31. Petitioner and its consolidated subsidiaries filed Forms 1120 for the taxable years 1974 and 1975 at the Kansas City Service Center, Kansas City, Missouri.

During the years 1974 and 1975, petitioner and its subsidiaries engaged in the invention, development, manufacture, marketing, and sale of ethical (i.e., prescription) and proprietary (i.e., nonprescription) pharmaceutical products; the manufacture and sale of a wide variety of hospital supply products; the manufacture and sale of compressed gases and related equipment for use in laboratories and industry; the development, manufacture, and sale of medical and scientific instruments; the manufacture and sale of food enzymes; and the manufacture and sale of eyeglasses and contact lenses. Petitioner and its subsidiaries *23 and affiliates conducted activities in approximately 90 countries and in 1975 employed approximately 19,400 individuals.

Total consolidated sales (excluding intercompany sales) of petitioner and its worldwide subsidiaries and the U.S. pharmaceutical sales (including intercompany sales) of petitioner for the years 1960 through 1975 were as follows (000's omitted): Year Consolidated sales U.S. pharmaceutical sales

1960 $ 36,907 $ 30,633

1961 44,778 36,494

1962 56,626 46,048

1963 71,417 59,036

1964 86,526 70,116

1965 88,970 70,721

1966 113,465 73,243

1967 132,707 81,700

1968 147,724 80,809

1969 163,936 1 85,779

1970 201,459 1 79,918

1971 226,891 2 47,520

1972 271,878 2 30,240

1973 471,681 2 31,698

1974 621,310 2 38,234

1975 711,800 2 46,734

*259 *24 B. SCO

SCO is a Delaware corporation whose principal place of business is Caguas, Puerto Rico. SCO was organized on January 13, 1969, as a wholly owned subsidiary corporation of petitioner. During 1974 and 1975, SCO maintained its books and records on the accrual method of accounting. Prior to August 1, 1974, SCO filed its tax returns on the basis of a fiscal year beginning on August 1 and ending on July 31 of each year. After August 1, 1974, SCO elected a short taxable year commencing on August 1, 1974, and ending on December 31, 1974. Since December 31, 1974, SCO has maintained its books and records and filed its tax returns on a calendar year basis. SCO filed Federal income tax returns on Forms 1120 for the taxable years 1974 and 1975 with the Office of International Operations, Philadelphia Service Center, Philadelphia, Pennsylvania. SCO also filed tax returns with the Commonwealth of Puerto Rico.

SCO was organized by petitioner for valid business reasons and to take advantage of the benefits provided by section 931 relating to income from sources within possessions of the United States. During 1974 and 1975, SCO was engaged in the manufacture and sale of ethical pharmaceutical *25 products in the Commonwealth of Puerto Rico.

II. History and Background of SCO's Products

A. Aldactone and Aldactazide

The active chemical ingredient in Aldactone is spironolactone. Aldactazide is a combination drug containing the two active chemical ingredients spironolactone and hydrochlorothiazide. Spironolactone was developed by researchers working at petitioner during the early 1950's. The spironolactone patent (No. 3,013,012) was obtained by petitioner on December 22, 1961. For a period of 17 years following the issuance of U.S. patent No. 3,013,012 , including during the years 1974 and 1975, U.S. patent law granted the owner of that patent the right to exclude others from making, having made, using or selling the invention, i.e., spironolactone, or pharmaceutical preparations, such as Aldactone and Aldactazide, that contained spironolactone, throughout the United States, including Puerto Rico. The *260 owner of a patent may grant to others by sale, license, or otherwise the right under the patent to make, use, or sell the product.

Hydrochlorothiazide was developed by Ciba Pharmaceutical Co. (hereinafter Ciba), during the late 1950's and patented by Ciba on *26 December 29, 1964. Petitioner registered the trademarks Aldactone and Aldactazide on April 5, 1960, and October 25, 1960, respectively. Aldactone was first marketed by petitioner in the United States in 1959, and Aldactazide was first marketed by petitioner in the United States in 1961.

Aldactone and Aldactazide are primarily prescribed for the treatment of edema (i.e., excess fluid retention). Edema is caused by the adrenal cortex's excessive secretion of aldosterone, a hormone that causes salt and fluid retention. Most drugs that treat edema are diuretics that work by increasing a patient's natural fluid excretion and, in the process, cause potassium loss. Aldactone works by blocking the effects of aldosterone and thus causes no potassium loss. Aldactone was promoted during 1974 and 1975 for edematous states associated with congestive heart failure and liver disease.

Aldactone, usually in combination with other drugs, and Aldactazide are also prescribed for the treatment of hypertension (i.e., elevated blood pressure). The causes of hypertension are not entirely understood, but it is known that excessive salt intake or retention plays a part. Consequently, the salt-retaining *27 hormone aldosterone is involved in hypertension as well as in edema. Hypertension is treated primarily with diuretics which lower blood pressure by causing salt and water excretion. As in the treatment of edema, the disadvantage of diuretics is that they cause potassium loss.

Aldactone and Aldactazide products, together, held the following annual percentage shares of the "Diuretics-oral" market category for the years 1968 through 1975: Year Market share

1968 9.3

1969 11.0

1970 11.9

1971 13.8

1972 16.0

1973 19.7

1974 21.7

1975 22.0

*261 Listed below are petitioner's and SCO's combined annual net sales and cost of goods sold in the United States of Aldactone and Aldactazide products for the years 1968 through 1975 (000's omitted): Year Sales Cost of goods sold

1968 $ 9,463 $ 2,307

1969 12,652 3,365

1970 15,372 3,371

1971 19,822 3,712

1972 26,815 4,666

1973 35,954 6,036

1974 42,901 7,498

1975 55,916 8,943

B. Banthine and Pro-Banthine

Banthine contains the active chemical ingredient methantheline bromide. Pro-Banthine contains the active chemical ingredient propantheline bromide. Methantheline bromide and *28 propantheline bromide were discovered by researchers at petitioner in the late 1940's and early 1950's, respectively, and patented on November 17, 1953. Thiopropazate and the dihydrochloride salt were patented on October 9, 1956. Neither patent was in effect during the taxable years before the Court. Banthine was introduced in the U.S. market in 1950, and Pro-Banthine was introduced in 1953. Petitioner registered the following trademarks with respect to those products: Trademark Date registered

Banthine Feb. 13, 1951

Pro-Banthine June 2, 1953

Dartal Dec. 17, 1957

Pro-Banthine P.A. Sept. 6, 1960

Probital Dec. 4, 1962

Banthine and Pro-Banthine primarily are prescribed for the treatment of peptic ulcers. Peptic ulcers are erosions of the mucous membrane of the esophagus, stomach, or duodenum caused by excessive secretion of hydrochloric acid by the stomach. That secretion is caused by impulses transmitted down the vagus nerve, facilitated by the release of the chemical substance acetylcholine. Prior to the discovery of Banthine and Pro-Banthine, the common treatment for peptic ulcers was surgery involving the cutting of the *262 vagus nerve. Banthine and Pro-Banthine *29 work by inhibiting the action of acetylcholine and thereby blocking the transmission of impulses down the vagus nerve. The two drugs were the first orally active drugs of that type, and are known as anticholinergics.

Banthine and Pro-Banthine competed during 1974 and 1975 with other anticholinergic drugs and with generic drugs containing propantheline bromide. Banthine and Pro-Banthine products as a group held the following annual percentage shares of the "Antispasmodic-Synthetic" prescription market category for the years 1968 through 1975: Year Market share

1968 38.6

1969 39.0

1970 38.9

1971 36.9

1972 36.4

1973 34.3

1974 34.0

1975 32.4

Listed below are petitioner's and SCO's combined annual net sales and cost of goods sold in the United States of Banthine and Pro-Banthine products for the years 1968 through 1975 (000's omitted): Year Sales Cost of goods sold

1968 $ 10,260 $ 739

1969 10,354 736

1970 10,541 1,288

1971 10,565 1,073

1972 11,001 1,616

1973 10,744 1,496

1974 10,483 1,639

1975 11,772 2,046

C. Flagyl The active chemical ingredient in the product Flagyl is metronidazole. Metronidazole *30 was developed and shown to be effective by researchers at Societe Des Usines Chimiques Rhone-Poulenc (hereinafter Rhone-Poulenc), a French pharmaceutical company, in the late 1950's. Rhone-Poulenc obtained a U.S. patent for metronidazole on July 5, 1960, which remained in effect during the taxable years in issue.

In 1960, petitioner acquired by license from Rhone-Poulenc the exclusive right to use and sell metronidazole products in the United States. Petitioner also acquired by license from Rhone-Poulenc the exclusive right to use and *263 later acquire the trademark Flagyl, which was registered by Rhone-Poulenc in the United States on September 8, 1959. To acquire those rights, petitioner agreed to pay Rhone-Poulenc royalties of 10 percent of petitioner's U.S. net sales of Flagyl products for use in humans and 5 percent of petitioner's U.S. net sales for use in animals. Petitioner at the same time separately agreed to purchase its entire requirements of metronidazole from Rhodia, Inc., a subsidiary of Rhone-Poulenc, for a price not to exceed 130 percent of Rhodia's cost of producing that chemical. Petitioner introduced Flagyl into the U.S. market in 1963.

Flagyl is prescribed *31 for the treatment of trichomoniasis, an infection of the urogenital tract caused by a protozoan organism. Trichomoniasis can infect both men and women, but produces visible symptoms only in women. It can be treated topically in women by the administration of creams or ointments, or it can be treated systemically (i.e., treating the body as a whole) in both men and women by orally administered Flagyl tablets. The infection can unknowingly be passed back and forth between sexual partners unless both are treated concurrently with a systemic trichomonacide. Flagyl is the only systemic treatment for trichomoniasis and is, therefore, the only treatment for trichomoniasis in men. Flagyl is also prescribed for the treatment of intestinal and liver amebiasis. Flagyl acts directly on the protozoa throughout the body in eliminating trichomoniasis and amebiasis.

Flagyl products held the following annual percentage shares of the "Trichomonacides" prescription pharmaceutical market category for the years 1968 through 1975: Year Market share

1968 41.7

1969 39.8

1970 37.3

1971 36.1

1972 37.7

1973 37.5

1974 48.0

1975 42.7

Listed below are petitioner's and SCO's combined *32 annual net sales and cost of goods sold in the United States of Flagyl products for the years 1968 through 1975 (000's omitted): *264 Year Sales Cost of goods sold

1968 $ 5,020 $ 837

1969 5,595 832

1970 6,321 1,088

1971 7,102 840

1972 8,139 1,113

1973 9,554 1,068

1974 10,396 1,421

1975 12,395 1,538

D. Lomotil

Lomotil contains the active chemical ingredients diphenoxylate hydrochloride and atropine sulfate. Diphenoxylate hydrochloride was developed in the late 1950's by Laboratoria Pharmaceutica Dr. C. Janssen, S.A. (hereinafter Janssen), a Belgian pharmaceutical company.

In 1957, pursuant to research sharing agreements between Janssen and petitioner, Janssen approached petitioner for assistance in obtaining the required Government approvals for marketing diphenoxylate hydrochloride in the United States. Janssen obtained a U.S. patent on the compound on August 4, 1959, which remained in effect during the taxable years in issue. Petitioner registered the Lomotil trademark on May 3, 1960. In 1962, Janssen and petitioner entered into a license agreement pursuant to which petitioner obtained the exclusive right to make, *33 4 use, and sell Lomotil products in the United States. In that agreement, petitioner agreed to pay Janssen a royalty of $ 25,000 per year plus 8 percent of petitioner's net sales of Lomotil for use in humans and 4 percent of petitioner's net sales of Lomotil for use in animals. Petitioner introduced Lomotil into the U.S. market in 1960.

Lomotil is prescribed for the treatment of diarrhea. Lomotil acts by decreasing the motility of the gastrointestinal tract and increasing the transit time of food through that tract, thereby permitting greater time for water absorption and bulking activity. The chemical atropine sulfate is an anticholinergic included in Lomotil in low, *265 subtherapeutic doses to prevent intentional abuse or overdosage of diphenoxylate hydrochloride. Lomotil's major competitors during 1974 and 1975 were opium-based *34 antimotility drugs and bulk water-absorbing agents.

Lomotil held the following annual percentage shares of the "Anti-Diarrheals without Anti-Infectice" market category for the years 1968 through 1975: Year Market share

1968 43.0

1969 47.2

1970 49.9

1971 52.3

1972 51.3

1973 50.9

1974 51.4

1975 55.4

Listed below are petitioner's and SCO's combined annual net sales and cost of goods sold in the United States of Lomotil products for the years 1968 through 1975 (000's omitted): Year Sales Cost of goods sold

1968 $ 8,315 $ 410

1969 10,456 557

1970 11,132 701

1971 13,328 973

1972 14,813 1,290

1973 15,441 1,041

1974 16,386 1,146

1975 18,859 1,113

E. Ovulen and Demulen

The active chemical ingredients in Ovulen are the synthetic progestrogen ethynodiol diacetate and the synthetic estrogen mestranol. Demulen also contains ethynodiol diacetate, but contains as its synthetic estrogen the chemical ethinyl estradiol. Ethynodiol diacetate was developed by petitioner's researchers in 1958 and was patented on July 15 of that year, and a process for making ethynodiol was patented on November 23, 1971. Mestranol and ethinyl *35 estradiol are unpatented commodity-type chemicals which have been generally available for many years. Petitioner registered the trademark Ovulen on September 24, 1963, and the trademark Demulen on April 7, 1970. Ovulen was first introduced into the U.S. market in 1966. Demulen, the result of joint research by petitioner and G.D. Searle & Co., Ltd. (hereinafter Searle, U.K.), its United Kingdom subsidiary, *266 was first introduced in Europe in 1969 and in the United States in 1970.

Ovulen and Demulen are combination oral contraceptives. Combination oral contraceptives have been marketed in the United States since petitioner introduced the oral contraceptive Enovid in 1960. By 1968, there were several oral contraceptive products competing with those sold by petitioner. All the combination oral contraceptives act by suppressing ovulation, without which conception and pregnancy cannot occur.

The major factor in the development of oral contraceptives in the 1960's and early 1970's was the concern with the possible side effects of those products. A strong interest in developing products with more potent estrogens or progestrogens that would be as effective in inhibiting ovulation *36 as their predecessors but at lower doses prompted the development of Demulen, which contained half the estrogen of Ovulen.

Ovulen and Demulen products held the following annual percentage shares of the "Oral Contraceptive" market category for the years 1968 through 1975: MARKET SHARE

Year Ovulen Demulen

1968 18.5 0

1969 19.9 0

1970 18.2 2.4

1971 15.4 5.6

1972 14.1 5.7

1973 13.1 5.5

1974 14.3 5.9

1975 12.8 6.1

Listed below are petitioner's and SCO's combined annual net sales and cost of goods sold in the United States of Ovulen and Demulen products for the years 1968 through 1975 (000's omitted): SALES

Year Ovulen Demulen

1968 $ 18,733 0

1969 20,378 0

1970 16,786 $ 3,537

1971 17,835 6,666

1972 Not available Not available

1973 $ 20,081 $ 8,373

1974 21,042 8,915

1975 23,398 11,193

COST OF GOODS SOLD

Year Ovulen Demulen

1968 $ 3,155 0

1969 3,279 0

1970 2,767 $ 612

1971 2,448 956

1972 Not available Not available

1973 2,455 1,147

1974 2,562 1,095

1975 3,013 1,381

*267 F. Serenace

*37 Serenace contains the active chemical ingredient haloperidol. Haloperidol is a tranquilizer prescribed for use in the management of acute and chronic schizophrenia, the manic phase of manic-depressive psychosis, and various other psychoses. Haloperidol was invented in the late 1950's by Janssen, which, under an agreement with petitioner, permitted petitioner to analyze and develop it for the U.S. market. Petitioner concluded that haloperidol was too potent to obtain wide acceptance in the United States and was likely to be positioned primarily as an institutional drug. However, petitioner determined that it could sell the drug in some markets outside the United States.

In 1962, petitioner acquired by license from Janssen the exclusive right to make and sell haloperidol in certain countries, excluding the United States and Japan. To acquire that right, petitioner agreed to pay Janssen a royalty of $ 10,000 per year plus 8 percent of petitioner's net sales of haloperidol for use in humans and 4.5 percent of petitioner's net sales of haloperidol for use in animals. In 1965, the agreement was amended to include Japan in the licensed countries. On April 15, 1969, Janssen obtained *38 a U.S. patent covering the compound haloperidol.

By a "Third Amendatory Agreement" between petitioner, Janssen, and SCO in 1970, SCO acquired the license under *268 Janssen's patent to manufacture haloperidol in Puerto Rico solely for export to Japan. Under the amendment, petitioner agreed to pay Janssen a paid-up royalty of $ 500,000 in addition to the royalties agreed upon in the original agreement. Petitioner never manufactured or sold haloperidol in the United States. Pursuant to its license from Janssen, SCO manufactured and sold haloperidol in Puerto Rico for export to Dainippon Pharmaceutical Co., Ltd. (hereinafter Dainippon), a Japanese pharmaceutical company, from March 1971 through 1975.

Listed below are SCO's annual net sales and cost of goods sold of Serenace for the years 1971 through 1975 (000's omitted): Year Sales Cost of goods sold

1971 $ 1,921 $ 118

1972 3,778 226

1973 2,721 178

1974 3,282 268

1975 3,171 352

III. Pharmaceutical Business of Petitioner and Its Subsidiaries Petitioner and its subsidiaries conducted their pharmaceutical business on a worldwide basis, with pharmaceutical manufacturing facilities in *39 21 foreign countries at the end of 1975. Petitioner's U.S. pharmaceutical operations were conducted through the Domestic Pharmaceutical Division of petitioner until 1972, when operations were assumed by petitioner's Searle Laboratories Division.

Petitioner's pharmaceutical operations in the United States prior to 1975 were conducted solely in a Skokie, Illinois, facility constructed during the 1940's. The facility contained chemical and pharmaceutical manufacturing and distribution facilities, administrative offices, and pharmaceutical research and development facilities. In 1974, petitioner acquired a chemical fermentation plant at Harbor Beach, Michigan. The Harbor Beach facility, which became operational in 1975, was used for the production of the chemical androstenedione. Petitioner also constructed a facility in Phoenix, Arizona, in 1975, which was used for the manufacture of the product Metamucil.

*269 Searle de Mexico, S.A. de C.V. (hereinafter Searle de Mexico) is a wholly owned subsidiary of petitioner, organized under the laws of Mexico. During the years 1968 through 1975, Searle de Mexico maintained two facilities in Mexico for the manufacture and sale of chemical *40 and pharmaceutical products. One of the activities of Searle de Mexico was the manufacture and sale of steroid chemicals refined from the native barbasco root harvested in Mexico. Searle de Mexico never conducted any operations in the United States.

G.D. Searle & Co., Ltd. (hereinafter Searle U.K.), is a subsidiary of petitioner organized under the laws of the United Kingdom. During 1974 and 1975, it maintained in the United Kingdom two facilities for the manufacture and sale of chemical and pharmaceutical products as well as facilities for pharmaceutical research and development. Searle U.K. sold the products it produced primarily in Europe and throughout the British Commonwealth. Searle U.K. never conducted any operations in the United States.

IV. Historical Development of the Puerto Rican Operations of Petitioner and SCO

A. Tax Incentives for Puerto Rican Operations

Prior to 1948, Puerto Rico based its economic development on Government ownership and operation of key industries. In that year, however, the emphasis shifted to the encouragement of private investment. Exemption from Puerto Rican income, municipal, property, and other taxes, under grants of industrial *41 tax exemption became the keystone of an industrial incentive program known as "Operation Bootstrap" that also included providing plants at low rent, cash grants to cover startup costs, employee training, and low interest loans. Through a series of legislative enactments in 1948, 1954, and 1963, Puerto Rico adopted laws granting qualifying companies total exemption from Puerto Rican taxes for varying periods of 10 or more years depending upon the geographic location of the company's operation in Puerto Rico.

The combination of U.S. and Puerto Rican tax incentives for doing business in Puerto Rico has been the prime *270 moving force behind remarkable economic growth in Puerto Rico. Puerto Rican total and per capita GNP have grown at nearly double the rate of growth in the United States since 1948. Employment in Puerto Rico's manufacturing sector nearly tripled between 1948 and 1975 despite significant declines in employment in the manual labor intensive industries such as textiles, apparel, and shoes.

B. Planning and Formation of SCO

In 1968, petitioner was in need of additional manufacturing facilities to service its U.S. pharmaceutical business. Its Skokie, Illinois, *42 facilities were old, outdated, and substantially overcrowded. In 1968, the crowding problem was so serious that GDS had been forced to institute shift work in both its chemical and pharmaceutical manufacturing and to hire contract manufacturers to package samples of its products. Use of multiple manufacturing shifts contravened basic company philosophy because control over product quality declined significantly during a second shift.

The Skokie location offered no opportunity for expansion of manufacturing facilities. Available land was severely limited and long-range company plans called for devoting what little additional space was available in Skokie to research facilities. Parking space was inadequate. Moreover, the facility was located practically in the center of downtown Skokie, thus making overly crowded manufacturing facilities an even more serious threat to neighborhood safety and increasing the difficulty of properly controlling pollution.

In the early 1960's, petitioner purchased land north of Chicago in Lake County, Illinois, as a possible site for manufacturing facilities. By late 1968, the overcrowding in the Skokie facility prompted petitioner to undertake architectural *43 planning and preliminary site work related to moving all of its U.S. pharmaceutical manufacturing to the Lake County site. Management estimated that it would have taken 2 to 3 years beyond 1968 to construct an operational manufacturing facility on the Lake County site.

In 1968, petitioner began considering the establishment of manufacturing operations in Puerto Rico. Petitioner was aware of the basic tax advantages of doing business in *271 Puerto Rico through prior experience. 5 Petitioner also knew that several other competing U.S. pharmaceutical companies with operations in Puerto Rico had a much lower effective tax rate as a result of those tax incentives than did petitioner. Accordingly, petitioner formed a project study group to evaluate Puerto Rico as a possible site for future operations in order to provide additional manufacturing facilities and as a means of saving taxes.

*44 The study group consisted of manufacturing, finance, and tax personnel of petitioner, as well as outside legal and tax advisors. The study group determined that Puerto Rico offered a labor supply that was plentiful, intelligent, easy to train, and cheap, relative to mainland standards. It also identified, with the assistance of officials of the Puerto Rican Government, a building in the Hato Rey section of San Juan that was being vacated by another pharmaceutical company and was available for lease. Because the building had been used for pharmaceutical manufacturing, it had in place the special air-conditioning, humidity control, dust collection, sewer, water, and related building services that would be required. As this building was readily adaptable to its needs, petitioner believed that it would be possible to begin manufacturing within 6 months.

Based upon the recommendation of its study group, petitioner decided to establish a manufacturing operation in Puerto Rico. SCO was organized on January 13, 1969, and was authorized to do business in Puerto Rico on February 21, 1969. Petitioner leased 60,000 square feet of the Hato *272 Rey building on February 28, 1969, and *45 an additional 20,000 square feet on July 1, 1970. Petitioner assigned these leasehold interests to SCO on July 1, 1970.

SCO was initially capitalized by a cash contribution from petitioner of $ 250,000. From the time of its initial issuance of shares to petitioner, and throughout 1974 and 1975, SCO was a wholly owned subsidiary of petitioner.

Petitioner's management described the basis for its decision to establish an operation in Puerto Rico in its 1969 Annual Report to Shareholders in the following terms:

The move to Puerto Rico was prompted by shortages of manpower and production capacity in Skokie. Our preliminary study showed that Puerto Rico could provide both an adequate labor supply and substantial savings in floorspace costs. In addition, the transfer enabled us to bring certain work into Skokie that formerly had been contracted to suppliers. Finally, we hoped to lessen the burden of income tax and to invest part of this saving in new research and development programs that otherwise would not be possible.

The transfers will not affect employment in Skokie where growth will continue. Our home facilities will be used for other production as well as providing backup capability.

*46 Early in 1969 and immediately after making the decision to establish an operation in Puerto Rico, petitioner's management began an examination of the products to be transferred to SCO. Daniel C. Searle, president and chief operating officer of petitioner, established three guidelines for the choice of SCO's products: (1) The product should be firmly established in the marketplace and have patent and trademark protection; (2) the product should have the potential for significant long-term profitability; and (3) the product should be capable of manufacture in Puerto Rico from a technical standpoint.

Petitioner's Puerto Rican study group examined all the company's product lines for possible transfer to SCO. Of petitioner's seven major product lines, five were selected for transfer to SCO. Those products were: (1) Aldactone/Aldactazide; (2) Banthine/Pro-Banthine; (3) Lomotil; (4) Flagyl; and (5) oral contraceptives. Because of the special manufacturing precautions required for oral contraceptive products, petitioner decided to defer the transfer of those products until manufacturing and related support procedures had been fully worked out for the other products. The *273 transferred *47 product lines were old well-established products that had been sold by petitioner in the United States for many years. They had each gained a substantial acceptance in the marketplace and were highly profitable, selling in 1968 at prices ranging from 4 to 20 times the direct cost of their manufacture. They were each protected by patents at the time of their transfer to SCO and each was strongly identified with a recognized and well-established trademark.

In 1968, the year before SCO was established, petitioner's U.S. total net sales of Aldactone and Aldactazide were more than 4 times its total direct costs of producing the drugs. By 1975, SCO's total net sales were more than 6 times the cost of production. Similarly, total net sales of Banthine and Pro-Banthine products were approximately 10 times its total direct production costs in 1968. Even after the patent on these products expired in 1970, SCO was able to maintain its sales on the strength of its trademarks. Total net sales of Flagyl in 1968 were 6 times its direct production costs and by 1975 the total sales were 8 times the cost of production. In 1968, total net sales of Lomotil were more than 20 times its total direct *48 manufacturing costs. In 1969, Ovulen net sales were 6 times its direct costs of manufacturing and in 1975 that ratio was nearly 8 to 1.

C. SCO's Puerto Rican Tax Exemption Grants Two basic tax exemptions were granted to SCO with respect to its operations during the years 1969 through 1975. By virtue of these tax exemption grants, SCO, during the years 1969 through 1975, was exempt from all Puerto Rican income tax on its qualified income (income from its manufacturing activities and certain investment income), municipal and Commonwealth taxes on real and personal property, license fees, and excise or other municipal taxes.

The first tax exemption grant covered the pharmaceutical manufacture of SCO's products. On January 10, 1969, on behalf of SCO (which was yet to be organized), petitioner filed an application for a tax exemption grant under the provisions of the Puerto Rico Industrial Incentive Act of 1963. The application covered Aldactone tablets, Aldactazide tablets, Flagyl tablets, Lomotil tablets and liquid, Enovid tablets (petitioner's first oral contraceptive *274 product), and Ovulen tablets. On February 12, 1969, petitioner filed an amendment to that application *49 to include Banthine with or without Phenobarbital tablets, Banthine vials, Pro-Banthine with or without Phenobarbital tablets, Pro-Banthine P.A. tablets, Pro-Banthine with Dartal tablets, and Probital tablets. By notice dated April 2, 1969, SCO was substituted for petitioner in the above applications. On November 7, 1969, SCO's initial grant of tax exemption covering the pharmaceutical manufacture of the above products was approved and issued by the Governor of Puerto Rico. The effective date of the 10-year grant of exemption was August 1, 1969.

The original pharmaceutical tax exemption grant was amended by decrees dated September 29, 1971, March 21, 1973, and December 13, 1974. Those amendments reflected the addition to SCO's product line of Flagystatin and Demulen, and SCO's move to a new manufacturing facility in Caguas, Puerto Rico.

On February 8, 1971, SCO applied for its second basic tax exemption grant. That grant, covering SCO's proposed chemical manufacturing operations, was issued on December 30, 1971, and was effective November 1, 1971, for a period of 10 years. The grant covered the manufacture of the following chemical products in bulk: spironolactone, ethynodiol *50 diacetate, propantheline bromide, haloperidol, and diphenoxylate hydrochloride. SCO's chemical manufacturing tax exemption grant was amended by decree dated August 8, 1973, and effective August 21, 1972, to permit the production of methantheline bromide. The grant of an industrial tax exemption did not require SCO to manufacture in Puerto Rico all of the products with respect to which such exemption was granted.

D. Initiation of Pharmaceutical Manufacturing by SCO

Petitioner's management next turned its attention to making SCO operational. It selected James S. Lawhead who had been an employee of petitioner since 1947 to become SCO's president and general manager. Mr. Lawhead held a master's degree in organic chemistry and prior to joining petitioner had been employed as a research and development chemist for two drug companies. He joined petitioner *275 as a development chemist and for 10 years conducted investigative studies on organic synthesis. Thereafter, Mr. Lawhead assumed various supervisory positions and, in 1967, became the Director of Manufacturing Operations. In 1969, Mr. Lawhead was offered the opportunity to manage SCO because the officers of petitioner *51 believed that his many years of experience made him eminently qualified to head the Puerto Rican operations. After accepting the position, Mr. Lawhead hired SCO's other executives, drawing both on petitioner's employee resources in Skokie and on Puerto Rican residents.

Preparation of the Hato Rey facility for the manufacture of SCO's products was under the direction of Mr. Lawhead and SCO's Director of Engineering, with support from petitioner's engineering department. SCO purchased approximately 25 percent of the initial manufacturing equipment needed at Hato Rey from petitioner at petitioner's net book value. The remainder of SCO's equipment was purchased new by SCO from unrelated U.S. vendors. Because SCO had not yet commenced operations, petitioner's purchasing department acquired the equipment on SCO's behalf.

Pharmaceutical manufacturing operations were instituted at SCO during 1969 and 1970 one product at a time. SCO manufactured its first tablets in June 1969, and sold its first products in August 1969. Set forth below are the month and year in which SCO first sold each of the products it manufactured. Product First sale

Aldactone tablets August 1969

Aldactazide tablets August 1969

Pro-Banthine with Dartal tablets December 1969

Pro-Banthine with Phenobarbitol tablets April 1970

Pro-Banthine tablets (half-strength) April 1970

vials May 1970

Banthine with Phenobarbitol tablets May 1970

Pro-Banthine P.A. tablets July 1970

Banthine tablets September 1970

vials September 1970

Flagyl tablets February 1970

vaginal inserts March 1970

Lomotil tablets May 1970

liquid August 1970

Ovulen October 1971

Demulen October 1971

*52 *276 E. Transfers of Intangible Property to SCO

During the years 1969, 1970, and 1971, petitioner and SCO entered into six agreements providing for the assignment and transfer by petitioner to SCO of its entire right, title, and interest in the following intangible property relating to SCO's products. Those agreements are as follows: Date Intangibles transferred Products covered

June 2, 1969 Patents, related technical Aldactone,

data, copyrights, and Aldactazide

trademarks

Oct. 1, 1969 Patents, related technical Banthine, Pro-Banthine,

data, copyrights, and Dartal and all

trademarks formulations and

combinations containing

the same.

Jan. 2, 1970 Metronidazole license from Flagyl

Rhone-Poulenc, related

technical data, and

copyrights

Apr. 1, 1970 Diphenoxylate hydro- chloride Lomotil

license from Janssen,

related technical data,

copyrights and trademarks

Mar. 3, 1971 Haloperidol license from Serenace 6

Janssen, related technical

data, and trademarks

Aug. 2, 1971 Patents, related technical Ovulen,

data, copyrights, and Demulen

trademarks

*53 The language of the June 2, 1969, agreement relating to Aldactone and Aldactazide is typical of the language contained in each of the six agreements. The agreement provides with respect to patents as follows:

SEARLE [petitioner] hereby assigns to SPR [SCO] all right, title, and interest in and to the Scheduled Patents. By virtue of said assignment, SEARLE grants to SPR the sole and exclusive right to make, use and sell under Scheduled Patents in the United States of America, its territories and possessions, including the District of Columbia and the Commonwealth of Puerto Rico * * * for the term of said Scheduled Patents as well as for the term of any extension or renewal thereof and to license and to sell or otherwise transfer to any other person or persons all or any part of SPR's rights under said Scheduled Patents on such terms and conditions as SPR may decide.

*277 The agreement contained similar language of assignment regarding technical data, trademarks, and copyrights relating to Aldactone and Aldactazide.

Petitioner and SCO filed, in the appropriate U.S. Government registration offices, acknowledgements of the transfers of ownership of the U.S. patents, trademarks, *54 and copyrights assigned pursuant to the six agreements. With respect to the contractual rights transferred, petitioner obtained from the other parties to the contracts their written consent to petitioner's assignment of those contractual rights to SCO. Upon entering into these agreements, SCO became the holder of legal title to the patents, trademarks, copyrights, contract rights, and related technical data.

Following their transfer to SCO and prior to the taxable years in question, three of the transferred patents expired. Those patents were: (1) U.S. patent No. 2,659,732 covering methantheline bromide and propantheline bromide, the active chemical ingredients in the Banthine and Pro-Banthine product lines; (2) U.S. patent No. 2,705,712 covering the chemical precursor to spironolactone, the active chemical ingredient of the products Aldactone and Aldactazide (a separate patent covering spironolactone remained in force through the end of 1975); and (3) U.S. patent No. 2,766,235 , covering thiopropazate hydrochloride, an active chemical ingredient in combination products containing Dartal.

Between 1971 and 1974, SCO registered in its own name numerous copyrights relating to its products. *55 More than 75 U.S. copyright registrations were obtained by SCO during 1974 and 1975. The documents for which SCO sought copyrights in 1974 and 1975 were prepared by or at the direction of petitioner's employees. The actual process of filing for copyrights was also performed or monitored by employees of petitioner as provided for in the Marketing Agreement.

F. Marketing Agreement

As SCO's manufacturing operations were being expanded, the procedures for SCO's sales of its products were being established. From August 1969, until approximately October 1, 1970, SCO sold the products it produced to petitioner. *278 Petitioner resold those products to unrelated wholesalers, hospitals, and clinics. Effective October 1, 1969, petitioner and SCO entered into a distributor appointment agreement appointing petitioner as nonexclusive distributor of SCO's products.

In September and October 1970, SCO began to sell its products directly to unrelated wholesalers in the United States. At that time, SCO entered into manufacturer-wholesaler agreements with each of its more than 400 drug wholesaler customers. Those wholesaler-manufacturer agreements established the terms and conditions *56 upon which SCO would sell its products to its customers. SCO's agreements with its wholesaler customers were renewed annually.

Effective September 1, 1970, petitioner and SCO entered into a marketing and sales promotion agreement (hereinafter the Marketing Agreement) whereby petitioner agreed to provide marketing and sales promotion services on behalf of SCO. 7 Under the Marketing Agreement, SCO agreed to pay to petitioner, for services rendered, a marketing fee equal to the greater of (1) 25 percent of SCO's net sales to customers in the United States, or (2) petitioner's cost of providing services to SCO plus 25 percent of such cost.

V. SCO's Manufacturing Activities

A. Acquisition of Chemical Manufacturing Facility at Caguas

Early in 1970, SCO began the process of developing its chemical manufacturing capability. The term "chemical manufacturing" refers to the manufacture *57 of active ingredients for pharmaceutical products. A search was undertaken by SCO's management for parcels of land suitable for construction of a chemical facility. On July 29, 1970, SCO acquired 4.84 cuedras of land from Phytogen Products, Inc., a subsidiary of Johnson & Johnson, Inc., together with an existing chemical manufacturing plant and chemical production equipment, for a combined purchase price of $ 1,100,000. The facility was located in Caguas, Puerto Rico, approximately 25 miles from SCO's Hato Rey plant.

*279 Following its acquisition of the chemical manufacturing facility from Phytogen Products, Inc., SCO remodeled the facility in order to make it suitable for performing certain manufacturing steps for the active chemicals used in SCO's pharmaceutical operations. The remodeling was directed by SCO's director of engineering with assistance from petitioner's engineering staff, and was performed by a local Puerto Rican construction company pursuant to an agreement with SCO. Set out below is the date on which SCO first manufactured each chemical that it manufactured in commercial quantities in its chemical manufacturing facility between 1971 and 1975: Bulk chemical Date of first manufacture

Propantheline bromide September 1970

Methantheline bromide March 1971

Haloperidol March 1971

Spironolactone April 1971

*58 SCO also used the Caguas facility for the recovery of spironolactone, hydrochlorothiazide, and propantheline bromide from pharmaceutical products that SCO's Quality Control Department determined could not be sold.

B. Construction of Pharmaceutical Manufacturing Facilities at Caguas

In late 1970 and early 1971, in addition to remodeling the chemical manufacturing facility, SCO constructed an adjacent pharmaceutical manufacturing plant for the production of oral contraceptives at the Caguas site. In order to accommodate the expansion and construction of the new facility, SCO acquired on May 19, 1971, two contiguous parcels of land totaling 5.84 cuedras. The design and construction of the facility were performed by the same Puerto Rican construction company that remodeled the existing chemical manufacturing facility. The work was supervised by SCO's Director of Engineering with some assistance from petitioner.

In 1972 and 1973, SCO expanded its facilities at Caguas by constructing a pharmaceutical manufacturing and packaging plant, plus additional office and warehouse space. Following completion of the construction in 1973, SCO consolidated all its operations at the Caguas *59 site. SCO vacated the Hato Rey facility and terminated its lease of *280 that facility. Of the 200 individuals employed at the Hato Rey facility, all except 7 made the move to Caguas.

The total cost and depreciated book value of SCO's property, plant, and equipment as of the end of 1973, 1974, and 1975, are set out below: Depreciated

Year Total cost book value

1973 $ 11,586,828 $ 10,446,521

1974 11,882,975 10,189,196

1975 12,268,000 9,951,000

C. Management and Personnel The original management of SCO consisted of five individuals, four of whom were former employees of petitioner. Of those five, the president, secretary-treasurer, and assistant secretary resided in Puerto Rico and had as their principal place of work during 1974 and 1975 SCO's facilities in Caguas, Puerto Rico.

During 1974 and 1975, operating executives of SCO included the Director of Chemical Operations, the Director of Pharmaceutical Operations, the Director of Engineering, the Director of Materials Management or Materials Control, the Director of Quality Control, the Director of Finance, the Director of Personnel, and the Director of Public Relations. All those management personnel *60 resided in Puerto Rico and had their principal place of work in Puerto Rico.

During 1974 and 1975, SCO's board of directors consisted of five individuals, three of whom were employees of petitioner in Skokie. The remaining two directors were employees of SCO in Puerto Rico.

As of December 31, 1974, SCO had 426 employees, 28 of whom were executives, officers, or managers. As of December 31, 1975, SCO had 454 employees, 29 of whom were executives, officers, or managers. Of the executives, officers, or managers mentioned, 21 in 1974 and 23 in 1975 were Puerto Rican. All the non-management employees in 1974 and 1975 were Puerto Rican.

D. Manufacturing and Related Activities

1. Products Manufactured and Sold SCO's manufacturing operations were instituted gradually one product at a time and one manufacturing step at a time *281 during 1969 and 1970. SCO manufactured its first tablets in June 1969 and sold its first products in August 1969. By September 1970, SCO was engaged in the pharmaceutical manufacture of the full line of Aldactone, Aldactazide, Lomotil, Flagyl, Banthine, and Pro-Banthine products.

During 1974 and 1975, SCO manufactured and sold directly, and almost *61 exclusively, to unrelated wholesalers, the following products in the following package sizes: National drug

Code No. Product Package size

0014-1011-31 Aldactazide tablets Bottle of 100 tablets

0014-1011-51 Aldactazide tablets Bottle of 500 tablets

0014-1011-55 Aldactazide tablets Bottle of 2500 tablets

0014-1011-66 Aldactazide tablets Carton of 10 boxes, each box

containing 100 individually

blister sealed tablets

0014-1001-31 Aldactone tablets Bottle of 100 tablets

0014-1001-51 Aldactone tablets Bottle of 500 tablets

0014-1001-55 Aldactone tablets Bottle of 2500 tablets

0014-1001-66 Aldactone tablets Carton of 10 boxes, each box

containing 100 individually

blister sealed tablets

0014-1504-05 Banthine vials Box of 5 vials

0014-1504-25 Banthine vials Box of 25 vials

0014-1504-31 Banthine vials Box of 100 vials

0014-1501-31 Banthine tablets Bottle of 100 tablets

0014-1501-51 Banthine tablets Bottle of 500 tablets

0014-1511-31 Banthine with

Phenobarbital tablets Bottle of 100 tablets

0014-0071-71 Demulen tablets Box of six 21 tablet dispensers

0014-0071-13 Demulen tablets Box of twelve 21 tablet

dispenser refills

0014-0071-08 Demulen tablets Box of forty-eight 21 tablet

dispenser refills

0014-0071-63 Demulen tablets Box of 10 containers, each

holding one 21 tablet dispenser

and two 21 tablet dispenser

refills

0014-0071-09 Demulen-28 tablets Box of six 28 tablet dispensers,

each containing 21 Demulen

tablets and 7 placebos

0014-0071-14 Demulen-29 tablets Box of twelve 28 tablet

dispenser refills

0014-0071-15 Demulen-28 tablets Box of 10 containers, each

holding one 28 tablet dispenser

and two 28 tablet dispenser

refills

0014-1801-31 Flagyl tablets Bottle of 100 tablets

0014-1801-41 Flagyl tablets Bottle of 250 tablets

0014-1801-52 Flagyl tablets Bottle of 1000 tablets

0014-1811-10 Flagyl tablets Box of 10 vaginal inserts

0014-0061-31 Lomotil tablets Bottle of 100 tablets

0014-0061-51 Lomotil tablets Bottle of 500 tablets

0014-0061-55 Lomotil tablets Bottle of 2500 tablets

0014-0061-66 Lomotil tablets Carton of 10 boxes, each

containing 100 individually blister

sealed tablets

0014-0066-02 Lomotil liquid Two ounce bottle

0014-0401-06 Ovulen tablets Box of six 20 tablet dispensers

0014-0401-12 Ovulen tablets Box of twelve 20 tablet dispenser

refills

0014-0401-07 Ovulen-21 tablets Box of six 21 tablet dispensers

0014-0401-13 Ovulen-21 tablets Box of twelve 21 tablet dispenser

refills

0014-0401-08 Ovulen-21 tablets Box of forty-eight 21 tablet

dispenser refills

0014-0401-63 Ovulen-21 tablets Box of 10 containers, each

holding one 21 tablet dispenser and

two 21 tablet dispenser refills

0014-0401-64 Ovulen-21 tablets Box of 100 containers, each

holding one 21 tablet dispenser and

two 21 tablet dispenser refills

0014-0401-09 Ovulen-28 tablets Box of six 28 tablet dispensers,

each containing 21 Ovulen

tablets and 7 placebos

0014-0401-14 Ovulen-28 tablets Box of twelve 28 tablet dispenser

refills

0014-0401-84 Ovulen-28 tablets Box of 10 containers, each

holding one 28 tablet dispenser and

two 28 tablet dispenser refills

0014-0624-05 Pro-Banthine 30 mg.

vials Box of 5 vials

0014-0624-25 Pro-Banthine 30 mg.

vials Box of 25 vials

0014-0624-31 Pro-Banthine 30 mg.

vials Box of 100 vials

0014-0601-31 Pro-Banthine 15 mg.

tablets Bottle of 100 tablets

0014-0601-52 Pro-Banthine 15 mg.

tablets Bottle of 1000 tablets

0014-0601-55 Pro-Banthine 15 mg.

tablets Bottle of 2500 tablets

0014-0601-66 Pro-Banthine 15 mg. Carton of 10 boxes, each

tablets containing 100 individually blister

sealed tablets

0014-0611-31 Pro-Banthine 7.5 mg.

tablets Bottle of 100 tablets

0014-0611-51 Pro-Banthine 7.5 mg.

tablets Bottle of 500 tablets

0014-0651-31 Pro-Banthine P.A.

30 mg. tablets Bottle of 100 tablets

0014-0631-31 Pro-Banthine with

Phenobarbital

tablets Bottle of 100 tablets

0014-0631-52 Pro-Banthine with

Phenobarbital

tablets Bottle of 1000 tablets

0014-0631-66 Pro-Banthine with

Phenobarbital

tablets Bottle of 2500 tablets

0014-0631-66 Pro-Banthine Carton of 10 boxes, each

Phenobarbital containing 100 individually blister

tablets sealed tablets

0014-0661-31 Probital tablets Bottle of 100 tablets

0014-0661-51 Probital tablets Bottle of 500 tablets

0014-0641-51 Pro-Banthine with

Dartal tablets Bottle of 500 tablets

*62 *283 During 1974 and 1975, SCO also manufactured the active chemicals spironolactone, propantheline bromide, and methantheline bromide for use as raw materials in its pharmaceutical manufacturing operations. During 1974 and 1975, SCO also manufactured and sold to Dainippon the chemical haloperidol, the active chemical in the product Serenace. SCO also engaged in manufacturing operations leading to the chemical recovery of the active compounds spironolactone, hydrochlorothiazide, and propantheline bromide from otherwise unusable lots of pharmaceutical products. During 1974 and 1975, SCO did not perform the chemical manufacturing relative to Flagyl, Ovulen, Demulen, or Lomotil products.

2. Production Planning and Scheduling SCO's production planning and scheduling was the responsibility of SCO's Director of Materials Control and his staff. Pursuant to the Marketing Agreement, petitioner's marketing staff provided SCO with quarterly sales forecasts of *284 sales of SCO's products. The first step in SCO's production planning and scheduling process was to revise the forecasts in view of SCO's experience and expectations and to take into account SCO's chemical and product *63 inventories. Having thus modified the sales forecast, SCO's materials management group prepared a quarterly production forecast of SCO's product needs. Based upon that production forecast, SCO's materials management personnel prepared periodic production schedules detailing the days on which the various required manufacturing and packaging operations would be carried out.

3. Inventory Control and Purchasing SCO maintained an inventory of more than 200 different types of raw materials necessary to its operations. Such materials were purchased from more than 65 separate suppliers. SCO's materials management personnel were responsible for maintaining adequate supplies of each of those raw materials.

Based upon their prepared production schedules, SCO's materials management employees prepared purchase requisitions for needed materials. Those requisitions specified for each purchase the amount to be purchased and the required delivery date. Each requisition also typically specified the vendor and often the purchase price of the material. In certain situations, an SCO purchase requisition could be prepared by petitioner's employees at Skokie, but only upon the telephone direction *64 of a responsible person at SCO.

For most of the more than 200 raw materials purchased by SCO, purchase orders were prepared and submitted to suppliers by employees in SCO's purchasing department. Those materials included all supply items purchased from Puerto Rican vendors, 8 chemicals purchased from Searle de Mexico and Searle U.K., chemical solvents, and packaging components. With respect to about 30 chemical raw materials, printed package inserts, and some packaging components *285 purchased from U.S. and "non-Searle" foreign vendors, purchase requisitions were sent by SCO's purchasing department to petitioner's purchasing department in Skokie. Petitioner's purchasing department kept on hand a limited number of SCO purchase order forms, pre-signed by SCO's purchasing manager. Generally, petitioner's purchasing department would complete the SCO purchase order, based upon the SCO prepared purchase requisition, from an approved vendor list and mail it to the vendor. In some cases, petitioner's purchasing agents would negotiate price and shipping arrangements with the supplier, although the ability to negotiate such matters was severely limited due to the fact that many *65 of SCO's necessary raw materials were available only from one or two approved sources.

In cases where petitioner submitted an SCO purchase order to a materials vendor, copies of the purchase order were sent by petitioner to SCO. The supplier's invoice was sent to SCO either by petitioner or by the vendor directly, and SCO paid the vendor directly for the material. In nearly all cases, the materials were shipped direct from the vendor *66 to SCO. A small number of chemical raw materials were shipped first to petitioner at Skokie and combined with other materials being shipped to SCO for reasons of shipping efficiency and economy. After raw materials were received by SCO, they were stored in SCO's raw materials warehouse in Caguas, Puerto Rico. SCO held legal title to and bore the risk of loss with respect to all raw materials used in its operations.

SCO purchased from petitioner, on a regular basis, printed labels for its product. 9 Such labels were printed by petitioner in its own print shop. On occasion, SCO would purchase from petitioner limited amounts of packaging components or generic chemicals to satisfy temporary shortages experienced by SCO. Such purchases were of materials originally supplied to petitioner by unrelated parties and were sold to SCO at prices charged to petitioner by those unrelated parties. All SCO's other labeling materials, which included package inserts, labels, and boxes, were purchased by SCO from unrelated vendors. Some of the *286 unrelated vendors were vendors who supplied similar materials to petitioner.

*67 4. Chemical Sourcing Among the raw materials required by SCO in its manufacturing operations were the active chemical ingredients contained in its pharmaceutical products. SCO acquired the active chemicals for some of its products from unrelated parties. SCO purchased other active chemicals from Searle de Mexico, Searle U.K., 10 and petitioner. SCO manufactured still others in its own chemical manufacturing facility in Caguas, Puerto Rico.

The major chemical raw materials used in SCO's products are listed below: Principal chemical reactants

Pharmaceutical Active chemical used in manufacturing active

product ingredients chemical ingredients

Aldactone Spironolactone Aldadiene

Thiolacetic aid

Aldactazide Spironolactone Aldadiene

Thiolacetic acid

Hydrochlorothiazide Purchased by SCO

Banthine Methantheline bromide Diethylaminoethylchloride

hydrochloride (DEC)

Xanthanoic acid

Banthine with

Phenobarbital Methantheline bromide DEC

Xanthanoic acid

Phenobarbital Purchased by SCO

Demulen Ethynodiol diacetate Purchased by SCO

Ethinyl estradiol Purchased by SCO

Ovulen Ethynodiol diacetate Purchased by SCO

Mestranol Purchased by SCO

Flagyl Metronidazole Purchased by SCO

Lomotil Diphenoxylate

hydrochloride with

atropine sulfate Purchased by SCO

Pro-Banthine Propantheline bromide Diisopropylamino-ethylchloride

hydrochloride (DIPC)

Xanthanoic acid

Pro-Banthine Propantheline bromide DIPC

with

Phenobarbital Xanthanoic acid

Phenobarbital Purchased by SCO

Pro-Banthine Propantheline bromide DIPC

with Dartal Xanthanoic acid

Thiopropazate

dihyclrochloride Purchased by SCO

Serenace Haloperidol Chlorofluorobutyrophenone

(CFB)

Chlorophenylhydroxypiperidin

(CPP)

*68 *287 In terms of dollar cost, SCO's most significant raw material purchases generally were its purchases of active chemical ingredients. Listed on page 288 are the principal chemical raw materials, the primary suppliers, and the dollar amounts of those chemical raw materials purchased by SCO for use in its chemical and pharmaceutical manufacturing operations during 1974 and 1975. In addition to the chemicals listed on page 288, SCO purchased other generic chemical materials and ingredients from a variety of unrelated suppliers for use in its chemical and pharmaceutical manufacturing operations.

The active chemical ingredient in Aldactone and Aldactazide is spironolactone. Spironolactone is a steroid derived, during 1974 and 1975, from the barbasco root, a plant indigenous to the southern portion of Mexico. The Mexican Government imposes prohibitively high export duties on the export of unrefined barbasco root in order to stimulate employment in Mexico. Accordingly, it was necessary to refine the barbasco root in Mexico. During the years in issue, Searle de Mexico refined the barbasco root and manufactured the last-stage intermediate chemical, Aldadiene, for sale to SCO. *69 SCO, using the Aldadiene as a starting material, performed the last of 15 steps in the manufacture of the chemical Spironolactone in its facility in Caguas, Puerto Rico. Immediately before the transfer of the products Aldactone and Aldactazide to SCO, petitioner also had manufactured spironolactone from Aldadiene it acquired from Searle de Mexico, although in earlier years petitioner had performed the additional Aldadiene manufacturing step in Skokie, Illinois. *288 Pharmaceutical product

to which chemical

Chemical purchased related Principal supplier

Aldadien Aldactone Searle de Mexico

Aldactazide

Thiolacetic Acid Aldactone Evans Chemetics

Aldactazide

Hydrochlorothiazide Aldactazide CIBA Pharmaceutical

Co.

Metronidazole Flagyl Rhodia, Inc.

Diphenoxylate

Hydrochloride

with Atropine Sulfate Lomotil Mallinckrodt, Inc.

Ethynodiol Diacetate Ovulen Searle de Mexico

Demulen

Mestranol Ovulen Searle de Mexico

Ethinyl Estradiol Demulen Searle de Mexico

Diisopropylaminoethylchloride

hydrochloride

(D.I.P.C.) Pro-Banthine G.D. Searle & Co.

Xanthanoic Acid Pro-Banthine Mallinckrodt, Inc.

Banthine

Diethylaminoethylchloride

hydrochloride

(D.E.C.) Banthine Michigan Chemicals,

Inc.

Chlorophenylhydroxypipiridine

(CPP) Serenace

(haloperidol) G.D. Searle & Co.,

Ltd. (U.K.)

Chlorofluorobuytyrophenone

(CFB) Serenace

(haloperidol) G.D. Searle & Co.,

Ltd. (U.K.)

Thiopropazate

Hydrochloride Pro-Banthine with Dartal Mallinckrodt, Inc.

Phenobarbital Pro-Banthine with

Phenobarbital Mallinckrodt, Inc.

*70 Amount purchased Amount purchased

Chemical purchased in 1974 in 1975

Aldadien $ 3,936,000 $ 4,225,000

Aldactazide

Thiolacetic Acid Not available 36,828

Aldactazide

Hydrochlorothiazide Not available 894,735

Metronidazole Not available 1,179,188

Diphenoxylate

Hydrochloride

with Atropine Sulfate Not available 195,154

Ethynodiol Diacetate $ 1,007,000 536,000

Mestranol 68,000 0

Ethinyl Estradiol 13,764 Not available

Diisopropylaminoethylchloride

hydrochloride

(D.I.P.C.) Not available Not available

Xanthanoic Acid Not available $ 313,779

Diethylaminoethylchloride

hydrochloride

(D.E.C.) Not available Not available

Chlorophenylhydroxypipiridine

(CPP)

Not available Not available

Chlorofluorobuytyrophenone

(CFB)

Not available Not available

Thiopropazate

Hydrochloride Not available $ 23,688

Phenobarbital

Not available 13,234

*289 Aldactazide also contained the active chemical hydrochlorothiazide. Hydrochlorothiazide was, in 1974 and 1975, a patented product of Ciba, a company unrelated to petitioner and SCO. SCO purchased its supplies of hydrochlorothiazide from Ciba on a purchase order basis, *71 the same method by which petitioner had obtained the chemical prior to the transfer of the product Aldactazide to SCO.

The active chemicals in the products Banthine and Pro-Banthine, Methantheline bromide and Propantheline bromide, respectively, were manufactured by SCO in its chemical manufacturing facility in Caguas. The chemicals were manufactured from late stage intermediate chemicals purchased from petitioner and unrelated parties. During the period that petitioner manufactured methantheline bromide and propantheline bromide prior to its transfer of the Banthine and Pro-Banthine products to SCO, petitioner purchased the same intermediate chemicals from unrelated parties.

The active chemical ingredient in the product Flagyl, metronidazole, was purchased by SCO from Rhodia, Inc. Metronidazole had similarly been purchased by petitioner from Rhodia, Inc., prior to the transfer to SCO of the product Flagyl. The active chemical in the product Lomotil, diphenoxylate hydrochloride, was purchased by SCO from Mallinckrodt, Inc. (hereinafter Mallinckrodt). Diphenoxylate hydrochloride similarly had been purchased from Mallinckrodt by petitioner prior to the transfer of the product Lomotil *72 to SCO. Diphenoxylate hydrochloride is a narcotic which is subject to extensive manufacturing and prescribing controls. However, because the diphenoxylate hydrochloride in Lomotil was combined with the anticholinergic atropine sulfate, Lomotil was classified as an "exempt narcotic" subject to less stringent controls than those applied to disphenoxylate hydrochloride alone. By purchasing the diphenoxylate hydrochloride already in combination with atropine sulfate from Mallinckrodt, a supplier approved by the Bureau of Narcotics and Dangerous Drugs, petitioner thereby avoided the necessity of complying with the strict regulatory requirements applicable to the manufacturers of narcotics and the expenses resulting from such compliance.

*290 The active chemical ingredients in SCO's oral contraceptive products, Ovulen and Demulen, are the synthetic progestogen ethynodiol diacetate and the synthetic estrogens mestranol (Ovulen) and ethinyl estradiol (Demulen). Those chemicals were synthetic steroids acquired by SCO from Searle de Mexico. During 1974 and 1975, the only raw material from which those chemicals could be manufactured was the Mexican barbasco root. As with the Aldactone/Aldactazide *73 chemical, because of Mexican Government restrictions, it was necessary to refine the barbasco root in Mexico. Accordingly, during the period that petitioner manufactured Ovulen and Demulen, petitioner purchased the raw active chemical ingredients for the chemicals ethynodiol diacetate, mestranol, and ethinyl estradiol from Searle de Mexico. Petitioner performed the final steps of the chemical manufacture of those chemicals in its facility at Skokie, Illinois. After the commencement of SCO's manufacturing operations, the complete chemical manufacture of ethynodiol diacetate, mestranol, and ethinyl estradiol was performed by Searle de Mexico.

The active chemical ingredient in the product Serenace, haloperidol, was manufactured by SCO in its chemical manufacturing facility in Caguas, Puerto Rico. SCO used as starting materials in those chemical manufacturing operations two intermediate chemicals manufactured and sold to SCO by Searle U.K.

5. Chemical Manufacturing During the years 1974 and 1975, SCO manufactured the active chemical ingredients for use in the pharmaceutical manufacture of its Aldactone, Aldactazide, Banthine, Pro-Banthine, and Serenace products. The chemical *74 manufacturing process began with the issuance, by SCO's manager of chemical manufacturing, of a production ticket for the particular lot of chemical to be manufactured. The chemical processes involved consisted of additions to and reactions with late or last-step chemical intermediates purchased by SCO. The resulting solutions were filtered, washed, distilled or crystallized, dried, recrystallized, and milled. The processes required from 3 to 8 workdays per lot, depending upon the chemical manufactured. The mixing of reactants *291 often took place in the presence of solvents or catalysts, and were sometimes heated under controlled pressure. Some of the chemical manufacturing procedures conducted by SCO involved exposure to chemical drug substances having potentially harmful side effects so that special equipment and precautions were necessary.

SCO's chemical manufacturing department worked a 40-hour week. The department consisted of a manager, 2 supervisors, and approximately 12 production workers. The manager of the department, as well as the 2 production supervisors, had college degrees in science. The production workers involved in the chemical manufacturing operations *75 generally were high school graduates. Certain of SCO's operations require operators to have as much as 2 years on-the-job training.

The active chemicals produced by SCO were thoroughly tested by SCO's quality control department for the satisfaction of each chemical's quality control tests. Chemicals that satisfied those tests were placed in SCO's warehouse for use in its pharmaceutical manufacturing operations. Materials failing those tests were rejected and returned to chemical manufacturing for reworking, recovery of active ingredients, or destruction.

6. Pharmaceutical Manufacturing and Packaging The term "pharmaceutical manufacturing" refers to the production of the final dosage forms of pharmaceutical products in tablet, liquid, or vial form and the packaging of said products. With reference to tablets, pharmaceutical manufacturing includes the mixing and compressing of active and inert ingredients.

During the years in issue, SCO manufactured pharmaceutical products in several different dosage presentations. Those presentations included tablets, coated tablets, liquid, and sterile ampuls. Regardless of the dosage presentation, the pharmaceutical manufacturing process *76 of each lot of pharmaceutical product, ingredient, or bulk chemical began with the issuance of a production ticket by SCO's manager of pharmaceutical manufacturing. Production tickets for new lots of products were issued according to the production schedules prepared by SCO's materials management staff.

*292 SCO's pharmaceutical manufacturing department consisted of approximately 188 persons. Of those, approximately 144 were production workers. SCO's production workers generally had high school degrees, some technical education, and on-the-job training.

SCO's tableted products were manufactured by weighing and mixing the various active chemicals and inert additives. Those materials were moistened and blended, compressed by machine into tablets and, for Banthine and Pro-Banthine products, coated with a sugar solution to mask their disagreeable taste. The production tickets were periodically reviewed, equipment was cleaned and inspected, samples of the chemical mixtures and finished tablets were taken, and visual and laboratory tests were performed to determine the quality of the products manufactured.

The products that passed SCO's quality control testing were released for *77 packaging. Those that were rejected were assigned for pharmaceutical rework, chemical recovery, or destruction. Rework material was ground and included in subsequent lots of tablets. Chemical recovery was used to extract the active chemical ingredients from rejected tablets for later use.

The finished tablets were packaged by SCO in a variety of presentations, including bottles of various sizes and blister packages for oral contraceptive products. With the following two exceptions, SCO packaged all of the pharmaceutical products that it manufactured during 1974 and 1975. During 1974 and 1975, Sharp Corp. packaged blister-pack presentations of SCO's products other than oral contraceptives. In addition, during those 2 years, samples of SCO's products were packaged by petitioner. SCO paid petitioner the following fees for sample packaging services: Year Fees

1974 $ 1,425,000

1975 1,599,000

Purchase orders for such services were issued by SCO's purchasing department and such contract packagers billed SCO directly for their services.

In addition to tablets, SCO manufactured Lomotil in liquid form and Banthine and Pro-Banthine in sterile ampul form. *293 The *78 Lomotil liquid was manufactured by mixing, heating, and dissolving the active ingredients in a liquid solution. The process required 2 days to complete, after which the manufactured material was tested, placed into bottles, and packaged for shipping. The Banthine and Pro-Banthine sterile ampuls are used for direct injection by a physician into a patient's blood stream. Because of the method of delivery, the sterility of the product is of paramount importance. The active chemical ingredients were purified by being put in solution, filtered, recrystallized, and sieved. The ampuls and stoppers were then heat sterilized, filled and sealed in a special sterile room, and packaged for shipping.

Subsequent to final packaging of SCO's products and release of those packaged products for shipment by SCO's quality control department, the final packaged products were warehoused by SCO at its Caguas, Puerto Rico, facility. These goods were warehoused until such time as they were required to fill orders of SCO's customers. Generally, SCO attempted to maintain no more than a 6-week supply of finished goods in its warehouse awaiting sale to its customers. SCO maintained no warehouse facilities *79 outside of Puerto Rico.

7. Production Tickets A production ticket is a document listing the step-by-step procedures for the manufacture of the particular chemical or pharmaceutical product to which it relates. The production ticket contains instructions for operators to follow in their activities, and specifies the ingredients, materials, pressures, temperatures, reaction times, equipment, and quality control tests necessary for the manufacture of any particular active ingredient or finished product. The production ticket provides space for the operator, his supervisor, and quality control employees of SCO to sign and countersign at each stage of the process indicating that proper procedures have been followed. Some of SCO's chemical manufacturing processes require the production ticket to be signed as many as 60 times each by the operator and the supervisor. A completed production ticket, together with all supporting documentation, is referred to as a "batch record."

*294 The production tickets issued for each lot of a product were prepared from master copies of such production tickets. Master copies of the production tickets were maintained both by SCO in Caguas and *80 by petitioner in Skokie.

The manufacturing procedures contained in SCO's production tickets were the same as or similar to those used by petitioner when the products were manufactured in Skokie. SCO consequently used the same production tickets as were previously written and utilized by petitioner, with some modifications. Modifications to production tickets relating to SCO's chemical manufacturing activities were under the direction and supervision of SCO's chemical development personnel. Modified chemical manufacturing production tickets were written by SCO employees in the SCO chemical development laboratory, and reviewed and approved by SCO chemical manufacturing and quality control personnel.

Modifications to production tickets relating to pharmaceutical manufacturing were under the direction and control of SCO's pharmaceutical manufacturing personnel. SCO employees originated any necessary changes, and SCO employees evaluated and approved the changes. Approval by petitioner of the modifications to production tickets was not required before SCO could initiate such modifications in its manufacturing processes. However, petitioner's regulatory affairs personnel reviewed such *81 modifications to determine whether the submission of a supplemental New Drug Application (hereinafter NDA) to the FDA was warranted. During 1974 and 1975, there were no changes in SCO's procedures significant enough to require the filing of NDA supplements.

In 1975, petitioner and SCO undertook a revision of the format of all their pharmaceutical production tickets. The change was first suggested by SCO's Director of Quality Control. Upon his suggestion, a joint task force was formed consisting of petitioner's and SCO's quality control, manufacturing, and regulatory affairs personnel. The group agreed on a basic format, which was tested using one of petitioner's existing products manufactured in Skokie. SCO then provided substantive information for the revision of its production tickets to an employee in petitioner's quality control division. That employee prepared the information in *295 a uniform format, caused the new production tickets to be printed in Skokie's print shop, forwarded copies of those tickets to SCO for approval, and later traveled to Puerto Rico to train SCO's production workers and supervisors in the proper completion of the tickets.

8. Quality Control

*82 As of December 31, 1974 and 1975, SCO employed 39 and 49 people, respectively, in its quality control department, including 8 pharmacists and chemists. In the normal course of its operations, SCO performed all required quality control tests on raw materials and in-process products without assistance from petitioner. The tests included laboratory testing and assays of the physical and chemical qualities of all incoming raw and in process materials, and visual and manual testing of all packaging and labeling materials. In order to evaluate the raw materials, specimens of a statistical sample of all incoming raw materials were taken. These raw material specimens were subjected to laboratory testing and assay work. Packaging and labeling materials, including components, were examined visually and manually to determine conformity with specifications. Based upon the results of its quality control tests, SCO's quality control department released for use or rejected the shipment of the raw material tested. SCO's quality control department also sampled and tested the products manufactured by SCO at each stage of the manufacturing process. Each lot of product produced by SCO was sampled *83 and tested by employees of SCO's quality control department prior to its release for sale to customers.

SCO's quality control department reviewed recordkeeping, batch records, and packaging records maintained by SCO's personnel relative to manufacturing operations and related activities. Routinely, SCO's Director of Quality Control determined when to release each lot of finished goods for shipment to customers. When finished goods were released for shipment, all completed batch records and records of quality control tests relating to that lot were filed at SCO's facility in Caguas, Puerto Rico, together with the retention samples of the product. Copies of these records were forwarded to the quality control employees of GDS in Skokie, Illinois. In addition, selected retention samples were *296 forwarded to the employees of GDS's quality control department in Skokie.

With one exception, SCO also normally performed all quality control tests on finished products. SCO's quality control department did not have the facilities to perform stability testing on its finished products. That testing, to ensure that a drug does not lose its potency before the assigned expiration date, *84 was performed by petitioner in Skokie.

Petitioner employed 97 persons in its production quality control department as of December 31, 1975. While petitioner did not routinely perform quality control tests on materials and products of SCO, it did from time to time provide assistance, advice, or instruction to SCO quality control employees at SCO's request. Petitioner also performed approximately 20 analytical tests per year on SCO's raw materials. SCO reimbursed petitioner for the cost of the quality control assistance and testing performed at its request.

Some of the analytical test procedures used by SCO's quality control employees were prepared and approved by petitioner's personnel. Those procedures complied with the procedures prescribed in the U.S. Pharmacopoeia, a national drug compendium. SCO developed other test procedures it used in Caguas, Puerto Rico.

SCO developed and implemented Good Manufacturing Practice (hereinafter GMP) training programs with the assistance of petitioner. SCO had its own GMP manual, which was drafted by SCO employees in conjunction with quality control employees of petitioner. SCO employees also participated in drafting similar manuals with *85 petitioner for petitioner's use in Skokie.

9. Product Recalls A recall of a prescription pharmaceutical product is initiated by a company or by the FDA whenever a defect is discovered in a product that has been forwarded to the marketplace. When such a recall is initiated by the company, itself, it is referred to as a voluntary recall.

Prior to 1975, SCO had never recalled any of its products. In that year, however, SCO experienced recalls of seven lots *297 of its products. These recalls resulted from a variety of manufacturing and packaging defects, each limited to a single lot.

Recalls of prescription pharmaceutical products are considered very serious in the pharmaceutical industry and the recalls of SCO's products in 1975 were considered as such by personnel of SCO and petitioner. Recalls can be characterized based upon the seriousness of the problem with the recalled product. Category 1 recalls are life threatening. Category 2 recalls affect the therapeutic outcome but are not life threatening. Category 3 recalls are less serious and would not tend to affect the therapeutic outcome. The recalls of SCO's products in 1975 would have been characterized as either *86 category 2 or category 3 recalls. However, the number of recalls experienced by SCO caused great concern to SCO and petitioner's management.

The first recall experienced by SCO in 1975 involved the discovery that certain Aldactazide tablets had reddish spots caused by raspberry flavoring particles, which necessitated the recall of an entire lot of tablets. The second recall involved a lot of Probital tablets which had hollow cores and did not contain any active ingredient. The third recall involved a decision to reduce the shelf life of Pro-Banthine P.A. from 5 years to 2 years, and to recall products outstanding which had a shelf life of over 2 years shown on their labeling. The fourth and fifth recalls involved the bottling of Lomotil tablets in Aldactazide bottles. This required the recall of one lot of Lomotil tablets and one lot of Aldactazide tablets. The sixth recall involved Flagyl tablets which had a peppermint odor similar to the peppermint flavor used in manufacturing Aldactone and Aldactazide tablets. This recall involved an investigation of the source of the peppermint used in manufacturing Aldactone and Aldactazide tablets and analysis of the product to discover *87 whether residue of the peppermint remained in the Flagyl tablets. The seventh recall involved a lot of Flagyl tablets which were too thin as a result of the malfunctioning of a tablet press.

Recalls of SCO's products were initiated jointly by personnel of petitioner's quality control staff and SCO. The products recalled by SCO were initially returned to petitioner. *298 Some of the recalled products were then destroyed by petitioner and some were returned to SCO.

Petitioner's regulatory affairs personnel were responsible for the liaison with the FDA relative to recalls of SCO products. SCO employees participated in the investigation and accompanied FDA inspectors through on-site inspections in Puerto Rico. The FDA prepares drug defect reports relative to prescription pharmaceutical products about which complaints are received. Preparation and submission of these reports relative to SCO's products were handled by petitioner's personnel who were also responsible for the followup, reply, and statement as to corrective actions taken relative to said problems.

SCO's management viewed the series of recalls in late 1975 as a very serious matter. Mr. Lawhead concluded that the *88 recalls, and the manufacturing problems leading up to those recalls, evidenced deep-seated problems in SCO's manufacturing operations. As a result, he recommended to his immediate supervisors in Skokie that an audit team comprised of non-SCO employees be sent to SCO to conduct an in-depth review of SCO's operations. Petitioner's management agreed with this proposal and three experienced employees of petitioner were sent to SCO's facility in Caguas, Puerto Rico, and conducted a thorough on-site audit of SCO's operations from October 1975 through February 1976. The audit resulted in certain recommendations for the improvement of SCO's operations.

VI. Sale and Distribution of SCO's Products

A. Identity of SCO's Customers

From August 1969 until approximately October 1, 1970, SCO sold its products to petitioner. Petitioner resold SCO's products to unrelated wholesalers, hospitals, and clinics. During September and October 1970, SCO began to sell its products directly to unrelated drug wholesalers located in the United States. Effective September 1, 1970, petitioner and SCO entered into a Marketing and Sales Promotion Agreement. At the same time that SCO began to sell its *89 products to unrelated parties, SCO entered into manufacturer-wholesaler agreements with each of its more *299 than 400 drug wholesaler customers. The agreements which were renewed annually provided that title to SCO's products would pass to the customer upon delivery to a common carrier in Puerto Rico.

During 1974 and 1975, approximately 97 percent of SCO's sales were made by SCO directly to unrelated customers, primarily independent drug wholesalers. Generally, SCO's independent wholesale customers were also customers of petitioner as well as of most other pharmaceutical companies. SCO also sold products to petitioner for petitioner's resale to certain tax-supported hospitals. All SCO sales to petitioner were at SCO's standard prices to wholesalers.

SCO published and distributed to its customers its own retail and wholesale price lists. During the years 1969 through 1975, the prices at which SCO's products were sold to wholesalers were recommended by employees of petitioner. During 1974 and 1975, there were seven changes in SCO's price list on the basis of recommendations by petitioner's employees.

B. Orders of SCO's Products

Orders for SCO's products were made on *90 SCO's own order forms and addressed to SCO, P.O. Box 5110, Skokie, Illinois. SCO's forms listed only SCO's products. Such order forms were a different color from petitioner's order forms, but SCO's and petitioner's order forms used during 1974 and 1975 were similar in format and were mailed to the same address by customers.

Upon receipt of an SCO order form, the information from the form was immediately entered into petitioner's computer by one of petitioner's employees located in Skokie. 11 Orders thus entered were communicated without change to a computer terminal at SCO in Puerto Rico via a dedicated communication network. Generally, order processing was done the same day that the orders were received in Skokie.

*91 SCO received the orders via the communications network, generally on the morning after the order was received at Skokie. SCO filled the order for its products from inventory *300 in its warehouse located at its Caguas, Puerto Rico, facility. The order was then shipped by SCO, via public air carrier, directly to the customer that placed the order. Orders generally were filled by SCO within 2 days of their receipt. When an order was prepared for shipment, the items to be shipped were entered by SCO employees into the computer terminal in Puerto Rico and transmitted to petitioner in Skokie via the communications network. Invoices were prepared on a line-by-line basis in petitioner's computer. The information then was transferred back to SCO's computer terminal and its invoices were printed on the attached printer. SCO sent a copy of the invoice to the purchaser, generally within 2 days of shipment of the order. The SCO invoices directed that payment be made to SCO in Puerto Rico. In the event a product was temporarily out of stock, SCO communicated that fact to its customers on the invoice, which directed the customer to reorder.

C. Billing Procedures Purchasers of *92 SCO's products were billed directly by SCO. SCO's sales invoices were payable 50 days net from the date of the invoice and directed customers to make payment to SCO in Puerto Rico. SCO extended credit to its customers and bore exclusively the resulting risk that customers would pay late or not pay at all. SCO monitored its accounts receivable by means of a monthly accounts-receivable aging report prepared from information entered into petitioner's computer system by SCO's accounting personnel. If an account became delinquent, employees of SCO sent correspondence to the customer requesting payment. Copies of that correspondence were sent to employees of petitioner, who on occasion assisted with collection or billing problems. SCO bore the risk that its customers would make late payments for its products or that its customers would, for any reason, refuse or be unable to pay. If payment of an overdue receivable was not forthcoming, SCO put a credit hold on a customer's account. In 1974 and 1975, SCO wrote off as bad debts approximately $ 50,000 and $ 51,163, respectively.

*301 D. Other Distribution Procedures

Under the terms of purchase printed on SCO's order forms *93 and invoices and contained in its manufacturer-wholesaler agreements, title to all products sold by SCO passed to the purchaser at the time the products were delivered to the common carrier in Puerto Rico.

Under the terms of its agreements with its wholesalers, SCO obtained insurance on behalf of its customers, covering loss or damage to goods shipped from Puerto Rico while in transit. Negotiations with respect to that insurance were conducted by personnel of petitioner. Petitioner received the bills for such insurance and forwarded them to SCO. In the event of loss or damage to goods sold by SCO while in transit, petitioner, acting pursuant to the Marketing Agreement, assisted the wholesaler in filing and pursuing insurance claims, if requested to do so by the wholesaler.

Under the terms of SCO's manufacturer-wholesaler agreements, the return of goods was permitted under a published, uniformly applied policy. That policy was identical to the one contained in petitioner's manufacturer-wholesaler agreements. Goods could be returned by wholesalers, hospitals, and retailers if they were defective or if they had aged not more than 1 year past their expiration date. Qualifying returned *94 SCO goods were sent by wholesalers to petitioner and generally were forwarded by petitioner to SCO. SCO reimbursed petitioner or the wholesaler for the amounts credited to customers returning SCO's products. Petitioner's activities with respect to returned goods were provided for in the Marketing Agreement.

VII. Petitioner's Marketing Operations

A. Introduction

During the years 1974 and 1975, petitioner maintained a marketing and sales administration and customer service staff in Skokie as well as a field sales force operating throughout the United States. Petitioner's Skokie marketing staff and field sales force marketed petitioner's pharmaceutical products and provided marketing services to SCO under the Marketing Agreement.

*302 It is the practice of leading pharmaceutical firms such as petitioner to establish a brand name or trademark name for their chemical compounds once they are placed on the market. The value of a trademark lies in the knowledge and experience physicians associate with a product. Thus, trademarks of products with market acceptance have substantial value. All of the products marketed by petitioner had trademarks which were used in identifying *95 those products to physicians and other health care professionals.

B. Marketing of SCO's Products

The September 1, 1970, marketing agreement between petitioner and SCO required petitioner to perform marketing services on behalf of SCO in the United States and foreign installations of the U.S. Government. Marketing services were defined to include sales representation, sales administration, professional education, market and promotion planning, and advertising.

1. Sales Representation The method of sales representation typically employed in the pharmaceutical industry is the direct contact, or "detailing," method. Sales representatives call on physicians and other health care professionals to discuss (or give "details" about) their companies' pharmaceutical products and to urge the health care professionals to prescribe, recommend, or utilize those products. This method of promotion recognizes that physicians are the ones who most directly affect buying decisions relating to ethical pharmaceutical products.

Petitioner's principal method of marketing ethical pharmaceutical products involved the direct contact, or detailing, method. In addition, petitioner's marketing operations *96 included printed advertising and the distribution of printed literature, promotional activities at conventions and medical schools, and other promotional activities.

During 1974 and 1975, petitioner's sales force consisted of approximately 405 sales representatives, 37 district sales managers, 6 regional sales managers, and a national sales director. New sales representatives were hired by the district sales manager and were typically in their mid-20's. *303 They were selected on the basis of three standardized tests, two of which related to personality and one of which related to intelligence. Although petitioner did not require its sales representatives to have college degrees, approximately 72 percent of its representatives during 1974 and 1975 had either 2-year or 4-year college degrees and approximately 3 percent had graduate degrees.

During 1974 and 1975, initial training of new sales representatives was conducted by the district sales managers in the field. Each new sales representative received 4 weeks of product training during which he learned the specific medical attributes of petitioner's and SCO's products as well as the medical attributes of competitors' products. *97 Such training generally included oral and written examinations. Additionally, the district sales manager or an experienced sales representative spent approximately 6 months with the new representative calling on physicians in the field. At the end of approximately 12 months of employment, the new sales representative attended a 2-week training session in Skokie, where 1 week was spent introducing the new representative to the activities of petitioner's various departments, and 1 week was spent reviewing basic selling skills. After approximately 24 months of employment, the sales representative attended a 1-week training session in Skokie. Experienced sales representatives also received periodic training.

The principal activity of petitioner's sales representatives during 1974 and 1975 was calling on physicians. Sales representatives spent more than 60 percent of their time in this activity. The purpose of such visits was to explain the function of one or two pharmaceutical products and to deliver descriptive materials and samples. The sales representatives were conversant with the physicians about technical medical questions concerning petitioner's and SCO's products. If *98 a sales representative was unable to answer a physician's question, he would obtain the necessary information from or relay the question to petitioner's medical department. A typical sales representative of petitioner during 1974 and 1975 saw between five and seven physicians each working day and spent an average of 3 to 5 minutes with each physician.

*304 The balance of the sales representatives' time was spent primarily in contacting retail pharmacies, wholesalers, hospitals, and hospital and clinical pharmacies in order to check on product stock and to urge the customers to maintain supplies of petitioner's and SCO's products. A minor amount of time also was spent in arranging symposia and film presentations for health care providers.

The descriptive materials regarding SCO's products delivered to physicians by petitioner's sales representatives were all copyrighted by "Searle & Co., San Juan, Puerto Rico 00936." The materials identified the products involved by name; the boxed-in word "Searle," followed by a smaller "Searle & Co. San Juan, Puerto Rico 00936" was printed underneath. Beneath those words was printed: "Address medical inquiries to: G.D. Searle & Co. Medical *99 Department, Box 5110 Chicago, Illinois 60680." Petitioner's sales representatives identified themselves to physicians as "Searle sales representatives" or simply, "Searle men."

The work of petitioner's sales representatives was monitored by petitioner through a reporting system that processed and tabulated reports by the sales representatives of each call on a physician or other health care provider. Upon each visit to a doctor or other health care professional, the sales representative marked a card recording the visit and the product or products discussed. That information was transmitted to petitioner's marketing administration staff in Skokie for recording and tabulation. That information indicated that in 1974 and 1975, 77 percent and 90 percent, respectively, of the total sales effort by petitioner's sales force was with respect to SCO's products.

In 1974 and 1975, petitioner's sales representatives made a total of 764,521 and 769,482 calls, respectively, with respect to petitioner's and SCO's products, as follows: Number of calls

Type of call 1974 1975

M.D.'s (office based) 393,913 450,165

Interns and residents 68,332 76,894

Hospital staff 90,945 96,829

Total physicians 553,190 623,888

Hospital calls 53,292 52,868

Hospital dispensaries 4,538 3,685

Retail 137,824 72,545

Wholesaler calls $ 8,737 $ 8,419

Wholesaler meetings 582 423

Films 6,358 6,472

Symposia 1,182

Total calls 764,521 769,482

*100 *305 2. Marketing and Sales Administration

In addition to the selling function performed by the sales representatives, petitioner performed other marketing and sales administration services on behalf of SCO. In the area of sales administration, petitioner's marketing staff aligned sales territories, administered salaries, constructed exhibits, and distributed sales material. It also trained salesmen and administered special markets. In the area of professional education, petitioner arranged symposia and professorships, developed learning systems, and arranged an in-house publication. In the area of market and promotion planning, petitioner developed market plans for existing products, developed and scheduled advertising and sales material, provided sales forecasts, insured that all marketing materials complied with Federal, State, and local law and regulations (including FDA regulations) as well as its own worldwide corporate standards, performed advertising research and advertising media selection, and developed lists for direct mail marketing. In the area of advertising, petitioner's staff dealt directly with advertising agencies, directed advertising development, *101 and was responsible for media approval. Petitioner's marketing staff also performed long-range market planning. As of December 31, 1975, petitioner had 67 employees on its marketing staff in Skokie.

3. SCO's Marketing Fee Payments to Petitioner In 1974 and 1975, SCO paid petitioner marketing fees as provided for in the marketing agreement. This agreement called for fees based upon 25 percent of SCO's net sales in the United States, or petitioner's cost of performance plus 25 percent, whichever was greater. The marketing fees actually paid with respect to 1974 and 1975 were computed on the basis of 25 percent of SCO's net U.S. sales, since that *306 figure exceeded the amount petitioner determined to be its cost of performance plus 25 percent in those years. During the years 1970 through 1975, SCO paid petitioner the following marketing fees pursuant to the marketing agreement (000's omitted): Year Marketing fee

1970 $ 6,144

1971 14,524

1972 22,103

1973 $ 25,057

1974 27,522

1975 33,243

Petitioner incurred the following annual marketing expenses relative to SCO's products based upon the method employed by petitioner to compute its cost of performance as provided *102 in the marketing agreement (000's omitted): Petitioner's

Year marketing expenses

1974 $ 11,123

1975 14,861

4. SCO's Other Marketing Expenses In addition to the payment of the marketing fee to petitioner, SCO also paid marketing expenses to certain unrelated parties. These expenses included payments to journals for advertising space, payments to advertising agencies for services rendered, and expenses of professionals speaking at symposia. Such promotion was arranged by petitioner's employees in accordance with the terms of the marketing agreement. The amounts paid by SCO to unrelated parties for marketing and promotion in the United States during 1974 and 1975 are set forth below: Direct advertising and

Year other promotion expenses

1971 $ 3,032

1972 4,494,000

1973 3,717,000

1974 3,512,000

1975 5,589,000

In addition, SCO paid marketing fees to G.D. Searle Inter-American Co. of $ 232,000 in 1974 and $ 311,000 in 1975, and to Searle Caribbean (the corporate successor of G.D. Searle Inter-American Co.) of $ 40,000 in 1975 with respect to their marketing of SCO's products in Puerto Rico.

*307 The amounts paid by SCO to petitioner for sample *103 packaging expenses were based upon petitioner's costs. SCO's sample expenses including payments to petitioner for packaging are as follows: Year Sample expenses

1971 $ 1,095,000

1972 1,692,000

1973 1,849,000

1974 2,540,000

1975 2,402,000

VIII. Research and Development Activities

A. Introduction

The pharmaceutical industry is research intensive and most, if not all, leading pharmaceutical firms make extensive investments in research and development in order to discover new products to market. As used in this context, the term "research" refers to activities such as the creation of new compounds, screening compounds for potential product development, and studying initial toxicological effects. The term "development" refers to activities related to compounds that have been screened in research and either appear to have marketing potential or are already being sold. Development includes short- and long-term toxicology studies, development and improvement of manufacturing processes, production of clinical trial materials and performance of clinical trials. Clinical trials are studies of the effectiveness and safety of a drug in humans. The term "control" *104 refers to the performance of analytical assays on research materials, purchased materials, and manufactured items.

As early as the 1930's, petitioner's management had made the decision to invest heavily in research and development in order to develop products which could be marketed on a nationwide basis. During 1970 through 1975, the worldwide pharmaceutical research of petitioner and its consolidated subsidiaries was directed towards seven general therapeutic areas. These included the study of cardiovascular-renal diseases, gastrointestinal disorders, sexual disorders and reproduction, immunology and inflamatory *308 diseases, infectious diseases, metabolic diseases, and research on the central nervous system for the treatment of depression, convulsions, narcotic addiction, psychosis, and pain. In addition, other areas of pharmaceutical research included disease progression and therapeutic control. This research involved efforts to refine the manufacturing process of steroids, such as the raw materials used in the manufacture of Aldactone, Aldactazide, Ovulen, and Demulen products. Petitioner's research ultimately resulted in obtaining U.S. patents on a microbiological *105 process to provide the basic steroid chemicals used as early intermediates in the manufacture of spironolactone, in lieu of intermediates from barbasco root. However, during 1974 and 1975, all Aldactone and Aldactazide products manufactured by SCO used spironolactone.

There is a clear correlation in the pharmaceutical industry between extensive research and development expenditures and the introduction of new ethical products. However, in economic terms, a specific investment made in research and development necessarily involves a substantial degree of risk. In general, petitioner performed research on approximately 10,000 new drug compounds in order to isolate one compound which would ultimately be marketed. The average time span for taking a new drug compound from initial identification through the regulatory process to FDA approval was 8 years, during the period 1969 through 1975. Petitioner's approximate cost of development of an ethical pharmaceutical product that obtained FDA approval during the period 1969 through 1975 was $ 50 million. This cost included the amounts expended on products that did not successfully complete the regulatory review process to the marketplace.

*106 Pharmaceutical firms typically patent their newly discovered chemical compounds in order to exclude competing firms from marketing these compounds. A patent claim is the description of the invention contained in and protected by the patent. A patent may contain more than one claim. For a period of 17 years following the issuance of a new-composition-of-matter patent, U. S. patent law grants the owner of that patent the right to exclude others from making, having made, using, or selling the invention *309 throughout the United States, including Puerto Rico. Thus, the value of a patent lies in the exclusion of competitors from the market.

Patented pharmaceutical compounds must be submitted to the FDA to obtain its approval prior to their marketing in interstate commerce. The owner of a new-composition-of-matter patent may grant to others by sale, license, or otherwise the right, under the patent, to make, use, or sell the invention. Foreign pharmaceutical firms, having obtained U.S. patents for newly discovered chemical compounds, often enter into licensing agreements with U.S. pharmaceutical firms which are capable of obtaining NDA approval for the compounds and successfully *107 marketing those compounds in the U.S. market. During the years 1974 and 1975, only a small fraction of patented pharmaceutical compounds were ultimately marketed for sale in the United States.

B. Research and Development Facilities

1. Petitioner's Facilities During 1974 and 1975, petitioner maintained a pharmaceutical, chemical, and biochemical research, development, and control facility in Skokie, Illinois. In addition, Searle U.K., a wholly owned subsidiary of petitioner, also maintained a research and development facility at High Wycombe, England, during 1974 and 1975. Searle U.K. used these facilities primarily to engage in research in the field of molecular biology. Petitioner and Searle U.K. engaged in research and in product development activities relating to their own pharmaceutical products and those of petitioner's other subsidiaries. The pharmaceutical research and product development activities conducted by petitioner and Searle U.K. benefited petitioner and its worldwide subsidiaries and affiliates, including SCO.

During the years 1969 through 1975, petitioner maintained its historically high level of expenditures in pharmaceutical research and development. *108 In 1974 and 1975, the member firms of the Pharmaceutical Manufacturer's Association invested 11.7 percent and 11.6 percent, respectively, of their sales of pharmaceutical products in research and development. Petitioner and its consolidated subsidiaries *310 invested 13.1 percent and 11.8 percent, respectively, of worldwide pharmaceutical sales dollars in pharmaceutical research in those same years.

Petitioner's research and development staff in Skokie, Illinois, had the following number of employees in 1974 and 1975: Year Nonexempt Exempt 12 Total

1974 313 340 653

1975 311 364 675

The expenses incurred by petitioner *109 at its Skokie, Illinois, pharmaceutical and related chemical research and development facility with respect to research and development activities from 1953 to 1975 are set forth below and are based upon the expense allocations used in petitioner's books and records. Under petitioner's method of accounting, pharmaceutical and chemical quality control expenses and regulatory affairs expenses are included in research and development, and the numbers set forth below include expenses attributable to those activities. As of 1971, the research and development amounts set forth below also include expenses related to petitioner's biochemical research and development activity, an activity unrelated to its pharmaceutical and chemical manufacturing business (000's omitted): Research and

Year development expenses

1953 $ 1,565

1954 1,803

1955 2,069

1956 2,505

1957 3,095

1958 3,406

1959 4,309

1960 4,120

1961 4,302

1962 4,855

1963 5,078

1964 5,571

1965 7,862

1966 $ 8,316

1967 9,150

1968 11,881

1969 13,104

1970 15,911

1971 17,403

1972 18,476

1973 18,627

1974 24,203

1975 27,672

*311 In 1974 and 1975, *110 the amount of pharmaceutical research and development related expenses incurred by petitioner at its Skokie, Illinois, facility, not including biochemical and other nonpharmaceutical research and development expense, were $ 24,107,000 and $ 25,235,000. The pharmaceutical research and development expenditures of petitioner and its consolidated subsidiaries for the years 1974 and 1975 were $ 33,020,000 and $ 36,228,000, respectively, based upon the books and records of petitioner and its consolidated subsidiaries.

In 1974 and 1975, the pharmaceutical research and development related expenses incurred by petitioner at its Skokie facility, represented 15.9 percent and 13.8 percent, respectively, of the combined pharmaceutical sales of petitioner and SCO to third parties. Petitioner invested 63 percent and 54 percent of its U.S. pharmaceutical sales dollars in pharmaceutical research and development in 1974 and 1975, respectively. Petitioner's investment in pharmaceutical research and development activities at its Skokie, Illinois, facility exceeded its cost of goods sold in 1974 and was approximately 95 percent of its cost of goods sold in 1975.

2. SCO's Facilities SCO maintained, *111 at its facilities in Caguas, Puerto Rico, a pharmaceutical technology laboratory and a chemical development laboratory. Three employees of SCO in pharmaceutical technology and eight in chemical development engaged *312 in process trouble shooting and process improvement regarding the manufacturing processes and activities relative to SCO's products. In 1974 and 1975, the research and development expenses of SCO, generally consisting of reimbursement to petitioner, represented approximately 1 percent of SCO's net sales in each year.

C. Regulatory Requirements The Food, Drug and Cosmetic Act of 1938, as amended, 21 U.S.C. sections 301-392 (1982) , requires the submission to and approval by the FDA of an application prior to the introduction into interstate commerce of any new drug, including patented drugs. The application is referred to as a "new drug application" (hereinafter referred to as an NDA) for non-antibiotic drugs. A critical part of the large U.S. pharmaceutical companies' research and development function is the ability to obtain NDA's for new drug products. This ability is often considered a measure of the success of their *112 research and development activities.

Following the enactment of the 1962 amendments to the act, NDA's have been required to contain acceptable scientific data, including the results of animal studies and human clinical tests, which demonstrate the safety of the drug and its effectiveness for its intended use. Prior to the 1962 amendments, however, it was necessary only to demonstrate the drug's safety in order to obtain FDA approval. The FDA has the authority to require additional studies after the submission of the NDA. After NDA approval, significant changes in manufacturing, labeling, and packaging necessitate the submission of an NDA supplement and the approval thereof prior to implementation.

The starting point for new pharmaceutical product research is the synthesis of a new chemical compound or series of compounds. After synthesis, the new compound is tested in animals for pharmacologic activity and toxicity. If animal tests of pharmacologic activity are promising and there are no signs of toxicity, the compound is then submitted for initial clinical testing.

An Investigational New Drug Application (hereinafter referred to as IND) is required to be filed with the FDA prior *113 to the commencement of that stage of the research relative *313 to a new drug product in which clinical studies on humans are undertaken to determine tolerance and the therapeutic effect of the drug. Subsequent to 1962, IND's were required to be filed prior to seeking NDA's and as a prerequisite to obtaining authorization to modify labeling information relative to products already marketed to establish new therapeutic uses for said product.

Clinical studies are generally carried out in three phases. The first stage involves testing the compound's safety in a very limited number of normal volunteers. The second phase involves testing the product's safety and therapeutic effectiveness in a limited number of patients suffering from the condition the compound is intended to benefit. The third phase involves broader testing of the efficacy and safety of the compound in patients under conditions of actual practice.

After completion of clinical studies sufficient to demonstrate the compound's safety and efficacy, an NDA is submitted to the FDA. The submission and review of an NDA is a lengthy and difficult process. If an NDA is approved by the FDA, the applicant is permitted to *114 market the drug in the United States. During 1974 and 1975, an accepted average in the pharmaceutical industry was that 1 drug out of every 10 submitted for clinical testing would obtain NDA approval.

D. Petitioner's Regulatory Affairs Services Related to SCO's Products

Listed below are the dates that NDA's were filed by petitioner and approved with respect to each product manufactured and sold by SCO during the years 1974 and 1975: Product NDA No. Date filed Date approved

Aldactazide tablets 12-616 09/13/60 01/04/61

Aldactone tablets 12-151 09/22/59 01/21/60

Banthine tablets and

Banthine with

Phenobarbital tablets 7-390 03/15/50 05/08/50

Pro-Banthine tablets and

Pro-Banthine P.A. tablets 8-732 11/15/52 01/05/53

Pro-Banthine with

Phenobarbital tablets 9-014 03/27/53 04/27/53

Pro-Banthine with Dartal

tablets 11-368 01/09/58 08/05/58

Banthine vials 8-091 06/07/51 08/07/51

Pro-Banthine vials 8-843 02/19/53 04/17/53

Lomotil tablets 12-462 05/27/60 08/30/60

Lomotil liquid 12-699 11/18/60 01/17/61

Flagyl tablets and vaginal

inserts 12-623 09/16/60 07/18/63

Ovulen tablets, Ovulen-21

tablets 16-029 03/13/64 03/23/66

Demulen tablets 16-927 04/14/70 04/24/70

Demulen-28 tablets 16-936 05/06/70 12/08/70

Ovulen-28 tablets 16-705 09/15/67 10/02/67

*115 *314 During 1974 and 1975, petitioner filed no NDA's with the FDA.

All animal and human testing, as well as the preparation of all correspondence, associated with obtaining the IND's and NDA's with respect to SCO's products, was performed or contracted for by petitioner or one of its subsidiaries other than SCO.

In order to implement the 1962 amendments to the Food, Drug, and Cosmetic Act, the FDA commissioned a study of the efficacy of certain drugs that were on the market prior to 1962 by the National Academy of Sciences/National Research Council (NAS-NRC). The NAS-NRC study began in 1968 and included SCO's Aldactone, Aldactazide, Pro-Banthine, and Lomotil products. That study resulted in the issuance of so-called Drug Efficacy Study Implementation (DESI) notices with respect to ethical drugs which had been marketed prior to 1962 and which were determined after study of the drug by NAS-NRC to be efficacious. The proper procedure for a person other than the holder of the NDA to seek FDA approval of the marketing of an identical product subsequent to the issuance of the DESI notice with respect to that product, was to file an abbreviated NDA. Under such circumstances, it *116 was not generally necessary to file with the FDA evidence of the drug's safety and efficacy in the form of animal laboratory and human clinical studies. Any modification of the dosage of a product with respect to which a DESI notice had been issued would require such party to file a full NDA. Set forth below is a list of the SCO products with respect to which DESI notices were issued *315 prior to January 1, 1976, together with the date on which the DESI notice was issued. Product description Date of DESI notice

Aldactazide 02/06/73

Banthine 06/18/71

Banthine with Phenobarbital 07/27/72

Pro-Banthine 06/18/72

Pro-Banthine with Phenobarbital 07/27/72

Pro-Banthine with Dartal 06/22/71

Lomotil 07/08/72

No DESI notice was issued with respect to Aldactone prior to 1976.

At the time each of SCO's products was transferred to SCO, it was necessary to file an NDA supplement with the FDA. Set forth below are the dates that NDA supplements were filed by petitioner and approved with respect to the initial pharmaceutical manufacture and sale of SCO's products by SCO: Product NDA No. Date filed Date approved

Aldactazide tablets 12-616 03/31/69 09/19/69

Aldactone tablets 12-151 03/31/69 09/19/69

Banthine tablets and

Banthine with

Phenobarbital tablets 7-390 04/25/69 12/12/69

Pro-Banthine tablets 8-732 04/18/69 12/08/69

Pro-Banthine with

Phenobarbital tablets 9-014 04/18/69 12/12/69

Pro-Banthine with Dartal

tablets 11-368 04/18/69 09/29/69

Banthine ampuls 8-091 04/25/69 08/07/70

Pro-Banthine ampuls 8-843 04/18/69 08/07/70

Lomotil tablets 12-462 03/31/69 04/02/70

Lomotil liquid 12-699 03/31/69 09/09/69

Flagyl tablets 12-623 03/17/69 09/24/69

Ovulen tablets, Ovulen-21

tablets 16-029 04/25/69 10/24/69

Demulen tablets 16-927 01/28/71 10/01/71

Demulen-28 tablets 16-936 01/28/71 10/01/71

Ovulen-28 tablets 16-705 01/28/71 10/01/71

Ovulen-Fe-28 tablets 1 16-706 04/25/69 11/05/69

*117

At the time SCO established its chemical manufacturing operations at Caguas, Puerto Rico, it was necessary to file *316 NDA supplements with the FDA. Set forth below are the dates on which NDA supplement applications were filed by petitioner and approved with respect to SCO's chemical manufacturing operations. Product NDA No. Date filed Date approved

Aldactazide tablets 12-616 12/17/70 05/14/71

Aldactone tablets 12-515 12/17/70 05/14/71

Banthine tablets and

Banthine with

Phenobarbital tablets 7-390 05/21/71 06/14/71

Banthine ampuls 8-091 05/21/71 06/14/71 1

Demulen tablets 16-927 05/25/71 10/01/71 1

Demulen-28 tablets 16-936 05/25/71 10/01/71 1

Lomotil liquid 12-699 12/29/70 05/06/71 1

Lomotil tablets 12-462 12/29/70 05/06/71 1

Ovulen tablets 1 Ovulen-21

tablets 16-029 05/25/71 10/01/71 1

Ovulen-28 tablets 16-705 05/25/71 10/01/71

Pro-Banthine tablets 8-732 08/14/70 10/28/70

Pro-Banthine ampuls 8-843 08/14/70 10/28/70

Pro-Banthine with Dartal

tablets 11-368 08/14/70 10/28/70

Pro-Banthine with

Phenobarbital tablets 9-014 08/14/70 10/28/70

*118

At the time SCO moved its pharmaceutical manufacturing operation from its leased facility in Hato Rey to Caguas, it was necessary again to file NDA supplements with the FDA. Set forth below are the dates on which NDA supplement applications were filed by petitioner and approved with respect to each of SCO's products at the time of the transfer of SCO's pharmaceutical manufacturing operations from Hato Rey, to Caguas, Puerto Rico: Product NDA No. Date filed Date approved

Aldactazide tablets 12-616 05/30/72 03/01/73

Aldactone tablets 12-151 05/30/72 03/01/73

Banthine tablets and

Banthine with

Phenobarbital tablets 7-390 05/30/72 02/28/73

Pro-Banthine tablets 8-732 05/30/72 04/02/73

Pro-Banthine with

Phenobarbital tablets 9-014 05/30/72 04/02/73

Pro-Banthine with Dartal

tablets 11-368 05/30/72 02/28/73

Banthine ampuls 8-091 05/30/72 04/02/73

Pro-Banthine vials 8-843 05/30/72 04/02/73

Lomotil tablets 12-462 05/30/72 02/28/73

Lomotil liquid 12-699 05/30/72 02/28/73

Flagyl 12-623 05/30/72 02/12/73

Ovulen tablets, Ovulen-21

tablets 16-029 01/28/71 10/01/71

*119 *317 At the time DESI notices with respect to SCO's products were published in the Federal Register, it was also necessary to file NDA supplements with the FDA. Set forth below are the dates on which NDA supplement applications were filed by petitioner and approved with respect to SCO's products following publication of DESI notices: Product NDA No. Date filed Date approved

Aldactazide tablets 12-616 04/06/73 10/21/74

Banthine tablets and

Banthine with

Phenobarbital tablets 7-390 09/10/71 12/07/71

Banthine ampuls 8-091 09/10/71 12/07/71

Lomotil liquid 12-699 11/14/72 05/17/73

Lomotil tablets 12-462 11/14/72 05/17/73

Pro-Banthine tablets 8-732 09/10/71 12/10/71

Pro-Banthine ampuls 8-843 09/10/71 12/10/71

In conformity with FDA requirements of parties holding NDA's, petitioner filed periodic reports on FD Form 2252 with respect to its products, as well as SCO's products. Petitioner also submitted two studies to the FDA in 1976 as part of NDA supplements for purposes of lengthening the expiration date of Demulen-28 tablets. These studies were long term and were ongoing in 1974 and 1975.

In addition to the NDA supplements listed above, *120 petitioner submitted other NDA supplements with respect to SCO's products throughout the years 1969 through 1975. These NDA supplements dealt with various matters including expiration dates and changes in labeling and package inserts.

During 1974 and 1975, petitioner filed 10 IND's. In addition, petitioner continued clinical studies during 1974 and 1975 on 9 IND's submitted in previous years to explore *318 new products or new claims for existing products. Four of these IND's related to SCO's products and are as follows: Date filed IND No. Product Subject matter

06/03/74 10-706 Aldactazide Aldactazide in premenstrual

tension

09/12/74 10-968 Flagyl Flagyl I.V.

07/16/75 11-716 Aldactazide Aldactazide in essential

hypertension

09/08/75 11-832 Demulen Searle 1/35

All NDA supplements and IND's filed with respect to SCO's products during the period from 1969 through 1975 were filed by employees of petitioner. Petitioner was the holder and owner of all NDA's related to SCO's products.

A company selling ethical pharmaceuticals is required to obtain FDA approval of all product labeling, package inserts, and promotional material. Product labeling *121 must be submitted to the FDA any time a substantial change occurs. The regulatory approval of these documents was obtained by employees of petitioner.

E. Other Research and Development Activities Related to SCO's Products

1. Petitioner's Activities In addition to the regulatory affairs services performed by petitioner relative to SCO's products, petitioner also performed other research and development activities including: (i) The development of new dosage forms of SCO's products, (ii) the development of combinations of SCO products with other drug entities, such as the attempted development of the product Flagystatin, a combination of Flagyl with the generic drug nystatin, (iii) the development of improved chemical and pharmaceutical processes and formulations for existing products, (iv) long term animal toxicology studies relating to the safety of the SCO products, and (v) stability testing on certain SCO products. Petitioner also arranged for unrelated persons to perform clinical studies relating to new indications for SCO's products and animal safety studies relating to the long term safety of such products.

*319 2. SCO's Activities

SCO maintained a laboratory *122 in its Caguas, Puerto Rico, facilities for the purpose of developing and improving the chemical and pharmaceutical manufacturing procedures related to its products. During the period from 1972 through 1975, two modifications of the process for manufacturing the spironolactone chemical were developed in the SCO chemical development laboratory. These process improvements reduced the risk of pollution in that manufacturing process.

During 1973 through 1975, employees in SCO's chemical development laboratory also made improvements in the manufacturing processes relating to the chemical propantheline bromide. Prior to the development of these improved procedures, 60 percent of the lots of propantheline bromide manufactured by SCO were rejected by SCO's quality control department. As a result of the SCO developed process improvements, the rejection rate was reduced from 60 percent to zero and the production yield was increased by 29 percent or 50 kilograms per lot. The SCO chemical development group developed processes for the recovery of the active chemicals propantheline bromide, spironolactone, and hydrochlorothiazide from rejected lots of pharmaceutical products containing those *123 chemicals. These processes enabled SCO to avoid the considerable expense that would have resulted from the otherwise necessary destruction of unusable pharmaceutical products. SCO chemical development personnel also developed procedures for purifying talc for use in SCO's pharmaceutical manufacturing operations. None of the modifications and improvements developed by SCO's chemical development group required the filing of NDA supplemental applications to facilitate their use.

F. Research and Development of New Pharmaceutical Products

In 1969 and 1970, petitioner anticipated that it would manufacture and sell in the United States several new products then the subject of its new product research and development activities. Extensive clinical data had been gathered for these products and, based either on overseas *320 sales or on projections of U.S. demand, petitioner expected that it would derive significant profits from these new products. Petitioner's new product research focused on these products from 1969 through 1975. However, only one of these new products, Cu-7, was introduced into the U.S. market prior to 1976.

1. Aspartame During the mid-1960's, petitioner *124 discovered that a compound comprised of two amino acids, and later known as Aspartame, had an exceptionally sweet taste. One of the two amino acids is synthesized naturally in the human body and the other is found in a large number of everyday high-protein foods, such as milk. Unlike saccharin or cyclamates, Aspartame is metabolized as a protein and used by the body in the same way as the amino acids found in other foods. During 1969 and 1970, petitioner prepared information for a food additive petition to be submitted to the FDA. The initial approval to market Aspartame was obtained in July 1974. Petitioner anticipated that Aspartame would be a major product and would generate significant income. Taste tests had indicated that the taste of Aspartame was preferable to that of saccharin or the cyclamates. Moreover, petitioner had entered into an agreement with General Foods Corp. providing for the inclusion of Aspartame in certain of the food and drink products made by General Foods, thereby providing a huge market for Aspartame.

Petitioner acquired a 135-acre site in Augusta, Georgia, and started in 1973 to construct a plant to produce large quantities of Aspartame. Cost estimates *125 for this plant were as high as $ 80 million. Nearly $ 20 million was expended before construction was suspended in 1974. Petitioner projected that this one plant would generate sales revenues of over $ 100 million per year, and operating profits of approximately $ 30 to $ 35 million a year, and was consequently prepared to risk construction prior to obtaining FDA approval. During 1973 and 1974, in anticipation of the pending market introduction of Aspartame, petitioner produced an inventory of Aspartame valued at $ 8 million. This inventory included 300 million Aspartame tablets produced *321 during 1973 at petitioner's Skokie facility. During 1974, petitioner anticipated that it would soon obtain approval to use Aspartame in soft drinks which would have opened up a lucrative market for the product. Following initial FDA approval of Aspartame, two individuals raised objections to its sale. This caused the FDA to set up a public board of inquiry to review the objections. Petitioner agreed not to market Aspartame pending this review. The board of inquiry was delayed, however, as a result of an unrelated FDA investigation during 1975 of part of petitioner's research activities. *126 Aspartame was not sold in the United States prior to the end of 1975.

2. Norpace Norpace was developed by petitioner in the late 1950's for the treatment of abnormal rhythms of the heart, "cardiac arrhythmia." Although the product was developed to the point where, in the early 1960's, petitioner felt it had adequate material for an NDA, the product was shelved because petitioner's marketing division felt at that time that the market was too small and the major competing product, Quinidine, was less expensive than Norpace would be. Petitioner did license Norpace to Roussel-Uclaf which sold the product in Europe in the 1960's and early 1970's. Subsequently, in the late 1960's, when the demand for antiarrhythmic drugs increased significantly and the price of Quinidine increased, petitioner decided to seek approval to market Norpace in the United States. During 1969 and 1970, petitioner gathered the substantial clinical data that had been developed in Europe and discussed with the FDA the filing of an NDA for Norpace. Petitioner anticipated that Norpace would generate substantial income. The U.S. antiarrhythmic market was expanding, Norpace was more effective than its major *127 competitor, Quinidine, and had fewer side effects. An NDA was filed in 1970. In that same year the FDA decided to require extensive additional controlled clinical tests. Petitioner voluntarily withdrew its NDA in 1971. As of the end of 1975, Norpace had not been introduced in the United States.

*322 3. Depepsen

During the 1960's, petitioner developed Depepsen, a compound intended to accelerate the healing and prevent the recurrence of peptic ulcers. At that time, the market for products treating peptic ulcers, including gastric and duodenal ulcers, was very large, and as of the end of 1969, no medication comparable to Depepsen was available. By the end of 1969, petitioner had accumulated a considerable amount of animal and clinical data indicating that Depepsen was an effective agent in the treatment of gastric ulcers. In broad scale clinical trials, however, petitioner was unable to demonstrate clearly Depepsen's efficacy in the treatment of duodenal ulcers. As a result of uncertainty as to whether the FDA would approve Depepsen for use in duodenal ulcers and because the cost of manufacturing Depepsen would be high, petitioner decided, in the early 1970's, not to *128 pursue further the development of Depepsen.

4. Cu-7 In March 1970, petitioner signed an agreement under which it obtained a license to sell the intrauterine device Cu-7. While other intrauterine devices were being sold on the U.S. market at the time, petitioner believed that Cu-7 had considerably greater efficacy, and was almost as effective in preventing contraception as oral contraceptives. Based on an opinion of the FDA that Cu-7 should be classified as a device and not a drug, petitioner anticipated that it would introduce Cu-7 in the summer of 1971. However, in April 1971, the FDA reclassified Cu-7 as a medical drug rather than a device, requiring an NDA and the submission of more data than would be required for approval to market a device. As a result, final approval to market Cu-7 in the United States was not obtained until February 1974. Almost immediately after its introduction in 1974, Cu-7 was temporarily withdrawn by petitioner because of sterility and packaging problems, and it was not reintroduced until 1975.

*323 G. Petitioner's Research and Development of Synthetic Steroid Chemicals

In the early 1960's, petitioner began a research effort to develop *129 synthetic steroid chemicals. It was hoped that such synthetic steroids would provide an alternative basic chemical to the barbasco root and be used as starting materials for the active chemical ingredients in Aldactone, Aldactazide, and the various oral contraceptive products as well as other steroid-based products produced by petitioner and its subsidiaries. This research effort led to the development of a laboratory-scale chemical fermentation process for the synthesis of the chemical androstenedione (hereinafter AD). This laboratory-scale process was patented by petitioner's research scientists in 1972 and 1973.

In 1974, petitioner leased a chemical fermentation facility in Harbor Beach, Michigan, for the purpose of conducting work relating to the scaling up of the manufacturing process leading to the production of AD. In January 1975, petitioner purchased the Harbor Beach, Michigan, chemical fermentation plant. During 1975, petitioner manufactured AD at the Harbor Beach facility and sold the chemical to Searle de Mexico and Searle U.K. A portion of petitioner's synthetic steroid chemical development research was charged to SCO.

The AD process provided SCO with an alternative *130 source of the key raw material for the manufacture of Aldactone and Aldactazide products and relieved pressure on the market for barbasco root. The availability of this alternative source reduced the Mexican Government's leverage to increase prices for the root. However, during 1974 and 1975, none of the Aldactone or Aldaztazide manufactured and sold by SCO used spironolactone derived from AD. Rather, all Aldactone and Aldactazide manufactured by SCO used spironolactone derived from the traditional barbasco root process.

H. SCO's Payments for Research and Development

The following amounts were paid by SCO to petitioner with respect to research performed for each of the calendar years 1974 and 1975. *324 Amount of R & D

Year expense billed to SCO

1974 $ 902,000

1975 1,278,000

The monthly research and development expense invoices issued by petitioner to SCO reflect charges for time spent by employees of petitioner's regulatory affairs department in filing NDA's, IND's, and NDA supplements with respect to SCO's products. Petitioner was the holder of all NDA's with respect to SCO's products.

IX. Regulatory Oversight and Legal Matters

A. Introduction

*131 In order to ensure that approved current good manufacturing practices are followed in the pharmaceutical industry and that the requirements and representations contained in the NDA are being fulfilled, the FDA periodically inspects the manufacturing facilities of sellers of pharmaceutical products, such as SCO. In addition to the FDA, other governmental regulatory and purchasing agencies inspected SCO's facilities from time to time. These agencies included the Bureau of Narcotics and Dangerous Drugs, the Drug Enforcement Agency, the Veteran's Administration, the Defense Personnel Service Center, the Consumer Product Safety Commission, and various agencies of the Government of the Commonwealth of Puerto Rico.

Complaints received from physicians, pharmacists, wholesalers, or patients, directly or through sales representatives, relative to the undesirable action or inaction of SCO's products, including complaints regarding adverse reactions were routed to petitioner's medical communications department. Medical doctors or other employees in petitioner's medical communications department and regulatory affairs department would investigate the complaint, notify SCO of the complaint and *132 obtain SCO's assistance in the investigation, and would file any required reports with the FDA either on FDA Form 1639 or as part of the periodic reporting requirements of the FDA.

*325 B. 1975 FDA Investigation

In 1970, petitioner submitted a report to the FDA of an 80-week study on rats relative to the product Flagyl. The report did not indicate that the product was a carcinogen. In 1972, the FDA learned of an independent investigator's report which indicated that Flagyl was a carcinogen in mice. As a result, the FDA reanalyzed petitioner's 1970 study. During this reanalysis, the FDA discovered numerous errors in petitioner's original submission. FDA personnel determined that these errors were serious and asked petitioner to submit a corrected copy of the study. The study was resubmitted in 1974. Upon receipt of the resubmitted study, the FDA became concerned with some of the corrections to the original study and commenced an investigation of petitioner with respect to Flagyl in May of 1974. That investigation continued until May of 1975, at which time the FDA had not developed all the information it deemed necessary to validate the original study. In December *133 of 1974, petitioner submitted preliminary results of a 78-week study in rats, which indicated Aldactone was tumorigenic. A complete report on that study was submitted to the FDA in March of 1975. The FDA analyzed this report and found certain inconsistencies. As a result of these inconsistencies and the FDA's own evaluation of petitioner's studies relative to Aldactone, the FDA convened a Cardio-Renal Advisory Committee to determine whether any action should be taken because of the information contained in the 78-week rat study relative to the toxicity of Aldactone. The differences between the analyses of the 78-week rat study of Aldactone by petitioner and by the FDA were such that the Cardio-Renal Advisory Committee, as well as the FDA, were concerned and an inspection of petitioner was undertaken. Although the results of this investigation were not completely satisfactory, it was terminated prior to July of 1975.

On July 10, 1975, the U.S. Senate Subcommittee on Health chaired by Senator Kennedy held hearings on preclinical studies. The FDA's investigations of petitioner relative to Flagyl and Aldactone and certain allegations by FDA personnel of fraudulent practices were *134 aired at those hearings. As a result, during 1975 and 1976, the FDA conducted a major investigation of certain of the preclinical *326 research conducted by or at the direction of petitioner during the period from January 1, 1968, through July 1975. A portion of the research which was the subject of the investigation had been paid for by SCO.

As a part of its investigation, FDA teams were at Skokie constantly from October 6, 1975, through December 19, 1975. Some investigative activity continued over into early January 1976. These inspection teams reviewed records, inspected facilities, and interviewed petitioner's employees involved in pathology/toxicology research. The focus of the investigation was on research practices in general, including how research was organized, how data was recorded, and how raw data compared with reports. In preparing for this on-site review, petitioner located, organized, and catalogued preclinical research records relating to more than 25 products and compounds, not all of which were then marketed by petitioner or SCO. Eight of those products and compounds were SCO's products.

Because of the vast number of preclinical studies done by petitioner *135 from 1968 to 1975, it was not feasible for the FDA to do a complete investigation of all these studies. Therefore, the FDA on-site investigation teams sampled petitioner's preclinical studies and selected for detailed review various studies relating to the following products: (i) Aldactone

(ii) Aspartame

(iii) Cu-7

(iv) Flagyl

(v) Norpace

(vi) Ovulen

(vii) Synchro-Mate

Aldactone, Flagyl, and Ovulen were products of SCO in 1974 and 1975. Cu-7 and Synchro-Mate were products of petitioner in 1974 and 1975. Norpace and Aspartame were not sold by either petitioner or SCO in 1974 and 1975. The FDA investigation teams reviewed records of 25 separate animal toxicity studies relating to the seven products. Of these 25 studies, 9 related to products manufactured and sold by SCO. Thirteen of the studies related to Aspartame and Norpace.

*327 The possible administrative sanctions which could have resulted from the FDA's investigation of petitioner's preclinical studies of Aldactone, Flagyl, and other products in 1975 ranged from mere changes in the labeling of the products in order to reflect changes in the safety profile of the products, to preliminary steps to withdraw *136 the NDA for Aldactone, Flagyl, or any of the other products under investigation which could ultimately result in removal of the product from the market. Negative findings by the FDA could have adversely affected the perception of physicians and health care professionals as to the integrity of petitioner's research activities. Consequently, such negative findings could have adversely affected sales of the pharmaceutical products of SCO and petitioner, especially the sales of any specific products deemed carcinogenic or unsafe. The FDA's allegations of inconsistencies in the preclinical study information submitted by petitioner with respect to Flagyl and Aldactone and the ensuing investigation were given priority by petitioner in 1975. This priority led to the formation of a task force responsible for coordinating the activities in preparation of the FDA investigation and monitoring the on-site investigation. Beginning on July 11, 1975, the day after the hearings before Senator Kennedy, approximately 300 of petitioner's personnel began to collect petitioner's preclinical, animal and safety records, and documents which were not filed centrally within petitioner's research and development *137 section. In preparation for the on-site FDA investigation, petitioner selected technical staff personnel and organized them as escorts for the on-site FDA investigation teams. These personnel were briefed on the central file and mechanized information retrieval system which had been set up for purposes of the investigation, instructed on how to behave with the FDA inspection teams, how to monitor the FDA's activities, and how to meet the needs of the FDA teams for interviews and tours of the facility. A total of nine FDA inspection teams were provided space and escort service by petitioner's personnel during the period October through December 1975. In addition, outside legal counsel as well as petitioner's own legal department participated in the investigation.

*328 The FDA on-site inspection of petitioner's research records concluded on January 13, 1976. At that time, petitioner estimated the expenses incurred during 1975 relative to the investigation as follows: Indirect costs absorbed within organization unit (in house costs)

a. Corporation information services $ 440,000

b. Department of science 322,000

c. Other staff units 67,000

d. Corporate management 42,000

Total indirect costs 871,000

Direct labor costs

a. Intercompany transfers $ 15,599

b. Consultants and temporary services 1,556

c. Legal fees 101,704

d. Special rewards to employees 70,000

Total direct labor costs 188,859

Equipment and supplies

a. Absorbed within department of Science $ 14,000

b. Communications 4,000

c. Office supplies 18,000

d. Miscellaneous 350

e. Computer charges 37,000

f. Travel expenses 7,000

Total equipment and supplies 80,350

Total petitioner's estimated investigation-related

expenses 1,140,209

*138 SCO reimbursed petitioner for one-half of the 1975 estimated investigation related expenses, $ 570,105, during June 1976. The amount of the expenses incurred by petitioner relative to the investigation that were reimbursed by SCO were not deducted on petitioner's 1975 Federal income tax return.

C. Product Liability Insurance Petitioner and its worldwide subsidiaries purchased product liability insurance under a blanket policy. SCO was charged for and paid to petitioner a portion of the product liability insurance premium. In addition, SCO established a reserve for self-insurance to cover the possibility of product liability losses not covered by insurance. The total product liability insurance premiums and reserve for insurance paid or accrued by SCO with respect to 1974 was $ 557,000 and with respect to 1975 was $ 567,000. The total product *329 liability insurance premiums and reserve for insurance paid or accrued by petitioner with respect to its worldwide operations in 1974 was $ 1,970,000 and in 1975 was $ 2,061,000.

Petitioner determined that 65 percent of the insurance premiums associated with SCO's products should be allocated to and paid by petitioner because *139 petitioner bore the risk as the entity which innovated the products and performed the underlying research. Based upon extensive studies which concluded that the primary cause of liability of pharmaceutical companies was defective research or allegations relative to errors in research, 65 percent of the product liability insurance was deemed to be an expense of petitioner and was not reimbursed by SCO.

D. Pending Lawsuits

During 1974, there were pending against petitioner and/or SCO 195 lawsuits for damages allegedly resulting from the use of products manufactured by petitioner or one of its affiliates. Based upon the alleged dates of injury, 25 such lawsuits involved products definitely manufactured and sold by SCO. An additional 11 such lawsuits involved products which may have been manufactured and sold by SCO. The legal fees and related litigation expenses incurred by petitioner during 1974 in connection with the 25 lawsuits definitely involving products manufactured by SCO were $ 45,432.90. The legal fees and related litigation expenses incurred by petitioner during 1974 in connection with the 11 lawsuits which may have involved products manufactured and sold by SCO *140 were $ 14,362. Said legal fees and litigation expenses do not include internal corporate legal department expenses. One of the 25 pending lawsuits definitely involving products manufactured and sold by SCO was settled during 1974 by the payment to the plaintiff of $ 2,750.

During 1975, there were pending against petitioner and/or SCO 191 lawsuits for damages allegedly resulting from the use of products manufactured by petitioner or one of its affiliates. Based upon the alleged dates of injury, 42 such lawsuits involved products definitely manufactured and sold by SCO. An additional 21 such lawsuits involved products *330 which may have been manufactured and sold by SCO. The legal fees and related litigation expenses incurred by petitioner during 1975 in connection with the 42 lawsuits definitely involving products manufactured by SCO were $ 74,923.46. The legal fees and related litigation expenses incurred by petitioner during 1975 in connection with the 21 lawsuits which may have involved products manufactured and sold by SCO were $ 13,427.37. Said legal fees and litigation expenses do not include internal corporate legal department expenses. Two of the lawsuits that *141 may have or did involve products manufactured and sold by SCO were settled in 1975 by the payment to the respective plaintiffs of a total of $ 22,000.

During 1974 and 1975, legal services provided by petitioner on behalf of SCO were not separately billed but rather were considered to be part of the administrative services provided on behalf of SCO. SCO paid legal fees to the law firm of McConnell, Valdes, Kelley, Sifre, Griggs & Ruiz-Suria, San Juan, Puerto Rico, for legal services and advice related to tax, corporate, real estate, contract, labor, and litigation matters. The amount of such fees paid by SCO in 1974 was $ 20,760 and in 1975 was $ 29,500. SCO also paid an additional $ 2,700 to other law firms during 1974 and 1975. Petitioner incurred legal expenses of $ 661,311 and $ 903,012 in 1974 and 1975, respectively.

On December 4, 1967, petitioner filed suit in U.S. District Court, Eastern District of New York, against Generic Formulae, Inc., and William Broder alleging infringement by defendants of U.S. patent No. 2,659,732 relating to the active ingredients in the Banthine and Pro-Banthine lines of products. Following the assignment by petitioner to SCO of legal title *142 to that patent, SCO was added as a plaintiff in this suit. In February 1970, the U.S. District Court, Eastern District of New York, issued a final consent judgment in favor of petitioner and SCO. During the years 1969 through 1975, neither petitioner nor SCO filed or pursued any other legal action relating to infringement of patents, trademarks, copyrights, or other intangible property rights relating to SCO's products.

*331 X. Accounting and Administration

A. SCO's Finance and Accounting Department

As of December 31, 1974, and December 31, 1975, SCO maintained a finance and accounting department with 27 and 32 employees, respectively. SCO's finance and accounting department (i) maintained SCO's general and subsidiary ledgers and other records of original entry, (ii) monitored SCO's accounts payable and paid expenses of SCO, (iii) monitored SCO's accounts receivable and monitored collection of outstanding customer accounts, (iv) maintained SCO's payroll records and paid SCO's employees, and (v) prepared financial reports of SCO's operations including balance sheets, income statements, variance reports, and calculations of source of income. SCO paid fees of $ 53,984 *143 to Arthur Andersen & Co. for audit, tax, and related services during 1974 and 1975.

B. Petitioner's Information Systems Department

Petitioner's information systems department provided centralized computer systems resources to petitioner and its subsidiaries, including SCO. These resources included computer programming, systems design, and computer operations. Throughout 1974 and 1975, SCO maintained in the central computer system its order entry system, a lot control system, and its accounts receivable records. During 1974, SCO began to maintain its inventory control system in the central computer. Also during 1974, SCO's tablet weighing system was integrated with the central computer. During August 1975, SCO began to maintain its general ledger in the central computer. Communications between SCO and the central computer were via a leased telephone line. SCO did not have any computer programming personnel. During 1974 and 1975, SCO was billed directly by petitioner's information services department for computer programming services rendered on its behalf.

C. Payment for Administrative Services Among the types of administrative services performed by petitioner on *144 behalf of SCO were (i) purchasing assistance, (ii) materials handling and receiving assistance, (iii) engineering *332 assistance, (iv) equipment maintenance assistance, (v) accounting assistance including computerized accounting, (vi) legal assistance including product liability litigation, (vii) treasury assistance including advice and assistance relating to portfolio investments, and (viii) personnel development and employee benefits assistance.

No itemization of administrative activities performed by petitioner on behalf of SCO was maintained in 1974 and 1975. Rather, during the years 1974 and 1975, SCO paid petitioner an administrative fee equal to 3 percent of SCO's sales of its products in the United States. The amount of the administrative fee paid by SCO to petitioner with respect to 1974 and 1975 was $ 3,304,000 and $ 3,989,000, respectively. These fees were billed to SCO on a monthly basis.

Petitioner incurred general and administrative expenses of $ 26,282,000 and $ 33,660,000 in 1974 and 1975, respectively. The total general and administrative expenses of petitioner and its consolidated subsidiaries in 1974 and 1975 were $ 69,963,000 and $ 85,628,008, respectively.

*145 XI. Financial Results of Petitioner's and SCO's Operations

A. Petitioner's Acquisitions

Prior to July 29, 1966, petitioner and its consolidated subsidiaries engaged exclusively in the manufacture and sale of pharmaceutical products and related chemicals. Beginning in 1966, petitioner undertook a program to diversify its operations through corporate acquisitions. Set forth below is a partial list of petitioner's U.S. acquisitions during the years 1966 through 1975. Year of

Company acquired acquisition

Nuclear-Chicago Corp 1966

Curtis Breeding Service, Inc 1968

Medidata Sciences, Inc 1968

Buchler Instruments, Inc 1970

Will Ross, Inc 1973

Oxford Laboratories 1974

Tecna Corp 1974

Following 1966, petitioner also formed subsidiaries and thereby embarked in new lines of business in the United States, as follows: *333 Year business

Subsidiary commenced

Searle Reference Laboratories 1970

Searle Leasing Corp 1970

Searle Diagnostics, Inc 1971

Searle Educational Systems 1971

B. Sales Statistics

Total sales (excluding intercompany sales) and net income before taxes of petitioner and its consolidated subsidiaries for the years 1960 through *146 1975, as reflected in its annual reports, are set forth below (000's omitted). The following sales figures are those reported in the years in question and do not reflect any restatements of prior years' financial results to account for the impact of acquisitions. Total

consolidated Net income

Year sales before taxes

1960 $ 36,907 $ 15,111

1961 44,778 20,143

1962 56,626 28,484

1963 71,417 38,430

1964 86,526 47,837

1965 88,970 44,161

1966 113,465 43,424

1967 132,707 51,078

1968 147,724 54,512

1969 163,936 56,113

1970 201,459 50,560

1971 226,891 49,585

1972 271,878 53,388

1973 471,681 79,565

1974 621,310 90,864

1975 711,800 93,297

Petitioner's U.S. sales of all products for the years 1960 through 1975 were as follows (000's omitted): Year U.S. sales

1960 $ 30,633

1961 36,494

1962 46,048

1963 59,036

1964 70,116

1965 70,721

1966 Not available

1967 $ 102,432

1968 109,655

1969 109,312

1970 102,868

1971 77,165

1972 66,365

1973 241,580

1974 288,416

1975 311,856

*334 The worldwide pharmaceutical net sales of petitioner and its consolidated subsidiaries for the years 1960 through 1975 are set forth below (000's omitted). *147 Approximate worldwide

Year pharmaceutical sales

1960 $ 36,907

1961 44,778

1962 56,626

1963 71,417

1964 86,526

1965 88,970

1966 94,200

1967 107,021

1968 114,812

1969 126,428

1970 131,967

1971 151,002

1972 178,437

1973 217,151

1974 252,420

1975 306,864

Petitioner's approximate U.S. pharmaceutical sales, including intercompany sales, for the years 1960 through 1975 are set forth below (000's omitted): Approximate U.S.

Year pharmaceutical sales

1960 $ 30,633

1961 36,494

1962 46,048

1963 59,036

1964 70,116

1965 70,721

1966 73,243

1967 81,700

1968 80,809

1968 $ 80,809

1969 1 85,779

1970 1 79,918

1971 2 47,520

1972 2 30,240

1973 2 31,698

1974 2 38,234

1975 2 46,734

*335 P

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