102 T.C. 149 (1994), 11660-90, Seagate Technology, Inc. v. C.I.R.

Docket Nº:11660-90.
Citation:102 T.C. 149
Opinion Judge:WELLS, Judge:
Party Name:SEAGATE TECHNOLOGY, INC. and Consolidated Subsidiaries, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Attorney:Joel V. Williamson, William A. Schmalzl, Joseph R. Goeke, John Bleveans, Thomas C. Durham, Roger J. Jones, M. Ellen Robb, Clisson S. Rexford, and Scott M. Stewart, Chicago, IL, for petitioner. William E. Bonano, San Francisco, CA, John O. Kent, Los Angeles, CA, Christopher J. Croudace, Christophe...
Case Date:February 08, 1994
Court:United States Tax Court

Page 149

102 T.C. 149 (1994)

SEAGATE TECHNOLOGY, INC. and Consolidated Subsidiaries, Petitioner,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 11660-90.

United States Tax Court

February 8, 1994

Page 150

Joel V. Williamson, William A. Schmalzl, Joseph R. Goeke, John Bleveans, Thomas C. Durham, Roger J. Jones, M. Ellen Robb, Clisson S. Rexford, and Scott M. Stewart, Chicago, IL, for petitioner.

William E. Bonano, San Francisco, CA, John O. Kent, Los Angeles, CA, Christopher J. Croudace, Christopher J. Faiferlick, San Jose, CA, and Paul G. Robeck, Portland, OR, for respondent.

P, a corporation whose stock is publicly traded, is a leading manufacturer of hard disk drives for personal computers. During its fiscal year ended 1983, P organized S as a wholly owned subsidiary to manufacture component parts in Singapore for use by P in the manufacture of hard disk drives in the United States. During its fiscal year ended 1984, P expanded S's operations to include the manufacture of completed disk drives in Singapore. P contributed to S's capital certain intangibles for use in the manufacture of the completed disk drives. P purchases component parts from S for use in disk drives P manufactures in the United States. P also purchases completed disk drives from S for resale to third parties. P generally pays S's standard cost plus a markup of 25 percent for the component parts and completed disk drives. S also sells component parts and completed disk drives directly to its third party customers. Pursuant to a property transfer agreement, S agreed to pay P a royalty of 1 percent of certain " sales into the United States" . Pursuant to a marketing agreement, S agreed to pay P a commission of 5 percent on all of S's third party sales, except for sales to distributors in Southeast Asia, the Indian Subcontinent, and the China Basin. Pursuant to a services agreement, S agreed to pay P for certain costs P incurred in assisting S's operations. Pursuant to a cost-sharing agreement, S agreed to pay P for one-half of the research and development costs P incurred and identified as covered under the cost-sharing arrangement. S also agreed to reimburse P for certain warranty costs incurred by P's repair centers. On audit, R reallocated income from S to P pursuant to sec. 482, I.R.C. 1954. Held, respondent's reallocation of income to P is arbitrary, capricious, and unreasonable. Held, further: R does not bear the burden of proof for issues in the case, except as specifically noted in the opinion. Held, further: The royalty rate contained in the property transfer agreement is not an arm's-length royalty rate, and the transfer prices for the component parts and completed disk drives are not arm's-length prices. Sec. 1.482-2(d) and (e), Income Tax Regs., applied to determine the proper sec. 482 adjustments for royalty and component parts and completed disk drive issues. Held, further: P's definition of " sales into the United States" is not reasonable. Such term is defined to include all disk drives shipped to U.S. destinations regardless of where title to the property is transferred. Held, further: S paid P arm's-length procurement service fees. Sec. 1.482-2(b), Income Tax Regs., applied. Held, further: Fifty percent of the research and development costs is not an arm's-length share. Sec. 1.482-2(d), Income Tax Regs., applied to determine the proper arm's length share. Held, further: P is not entitled to an offset for warranty payments S paid P. Sec. 1.482-1(d)(3), Income Tax Regs., applied.

CONTENTS
Page
STATEMENT OF ISSUES 8
I. GENERAL FINDINGS OF FACT 9
A. Background in General 10
B. The Industry in General 11
C. Seagate Scotts Valley 13
D. Seagate Singapore 14
II. ISSUE 1: WHETHER RESPONDENT'S REALLOCATIONS OF GROSS INCOME UNDER SECTION 482 ARE ARBITRARY, CAPRICIOUS, AND UNREASONABLE 16
A. FINDINGS OF FACT 16
1. The Notices of Deficiency 16
2. Respondent's Expert Reports 16
B. OPINION 18
1. The Parties' Positions 18
2. Section 482 in General 18
III. ISSUE 2: WHETHER RESPONDENT SHOULD BEAR THE BURDEN OF PROOF FOR ANY OF THE ISSUES INVOLVED IN THE INSTANT CASE 21
A. FINDINGS OF FACT 21
1. The Notices of Deficiency 21
2. Respondent's Concessions 24
3. Respondent's Experts 25
B. OPINION 26
1. The Parties' Positions 26
2. The Court's Holding as to Burden of Proof 27
IV. ISSUE 3: WHETHER SEAGATE SCOTTS VALLEY PAID SEAGATE SINGAPORE ARM'S-LENGTH PRICES FOR COMPONENT PARTS 32
A. FINDINGS OF FACT 32
1. In General 32
2. Intercompany Transactions 33
3. Component Parts Manufacturing 34
4. Respondent's Notices of Deficiency 37
5. Petitioner's Experts 38
a. Daniel P. Broadhurst 38
b. Gary E. Holdren 38
c. Clark J. Chandler 39
6. Respondent's Experts 45
a. Thomas Horst 45
b. Grant M. Clowery 46
c. Steven M. Zemsky 49
7. Other Third Party Transactions 50
B. OPINION 51
1. Ultimate Findings of Fact 51
2. The Methods 51
a. The Comparable Uncontrolled Price (CUP) Method 53
i. The CUP Method in General 53
ii. The Parties' Positions on the CUP Method and the Court's Holding as to Its Application 54
b. The Cost-Plus Method 56
i. The Cost-Plus Method in General 56
ii. The Parties' Positions on the Cost-Plus Method as Applied by Dr. Horst and the Court's Ruling as to That Method 57
iii. The Parties' Positions on Applying the Cost-Plus Method Using the Bull Peripheriques Sale and the Court's Holding as to That Method 63
iv. The Parties' Position on Applying the Cost-Plus Method Using Dr. Chandler's Approaches and the Court's Holding as to That Method 64
c. The Court's Holding as to the Arm's-Length Transfer Price for Component Parts Sold to Seagate Scotts Valley 66
V. ISSUE 4: WHETHER SEAGATE SCOTTS VALLEY PAID SEAGATE SINGAPORE AN ARM'S-LENGTH PRICE FOR COMPLETED DISK DRIVES SEAGATE SINGAPORE PRODUCED AND SOLD TO SEAGATE SCOTTS VALLEY 68
A. FINDINGS OF FACT 68
1. Disk Drive Manufacturing and Sales 68
2. Respondent's Notices of Deficiency 76
3. Petitioner's Experts 79
a. Mr. Holdren 79
b. Mr. Broadhurst 89
4. Respondent's Experts 93
a. Dr. Clowery 93
b. Dr. Frisch 98
B. OPINION 106
1. Ultimate Findings of Fact 106
2. Analysis of Completed Disk Drive Issue 106
a. The CUP Method 107
i. Petitioner's Position 107
ii. Respondent's Position 108
iii. The Court's Holding as to the CUP Method 110
b. The Resale Price Method 115
i. Respondent's Resale Price Method 117
ii. The Court's Holding as to Respondent's Resale Price Method 121
iii. Petitioner's Resale Price Method 123
iv. The Court's Holding as to Petitioner's Resale Price Method 124
c. The Court's Holding as to the Arm's Length Transfer Prices for the Disk Drives 125
d. The Price Allowance and Allowance for Seagate Singapore's Marketing Activities Allowed by Respondent in the Notices of Deficiency 128
i. The Price Allowance 128
ii. The " Offset" for Seagate-Singapore's Marketing Activities 129
VI. ISSUES 5 AND 6: WHETHER SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY ARM'S-LENGTH ROYALTIES FOR THE USE OF CERTAIN INTANGIBLES AND WHETHER THE ROYALTY FEE SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY FOR DISK DRIVES COVERED UNDER A SECTION 367 PRIVATE LETTER RULING APPLIES TO ALL SUCH DISK DRIVES SHIPPED TO THE UNITED STATES, REGARDLESS OF WHERE TITLE PASSED 130
A. FINDINGS OF FACT 130
1. General Background Information 130
2. Seagate Scotts Valley and Seagate Singapore Agreements 132
a. The Property Transfer Agreement 132
b. The Royalty Agreement 135
c. The Marketing Agreement 136
3. The Ruling Request and Private Letter Ruling 137
a. The Request 137
b. The Private Letter Ruling 138
4. Royalties Paid 140
5. Third Party Licensing Agreements 141
a. Co. R and Co. S 141
b. Texas Instruments, Inc. 142
c. Honeywell Bull 143
d. TEAC Corp. 144
e. Co. K 145
f. Co. L 145
g. Co. M 146
h. IBM 146
i. Co. N 147
j. Co. B and Co. C Agreement 148
k. LaPine Technology and Kyocera Agreements 149
i. Research and Development Agreement 150
ii. Trading Agreement 151
iii. Technology Transfer and Manufacturing Agreement 152
l. Co. B and Co. F Agreement 154
m. Co. P and Co. Q Agreement 154
n. Co. D and Co. E Agreement 155
o. Co. G and Cos. H and J Agreement 156
6. Respondent's Notices of Deficiency 157
7. The Experts' Positions 160
a. Petitioner's Experts 160
i. Dr. Chandler 160
ii. James Patterson 161
iii. Zoltan M. Mihaly 162
iv. Paul M. Enlow 163
v. Mr. Holdren 164
vi. Mr. Broadhurst 165
b. Respondent's Experts 165
i. Dr. Horst 165
ii. Anthony LaPine 168
iii. Mark R. Sherwood 170
iv. Harold J. McLaughlin 172
v. George E. Frost 172
B. OPINION 175
1. Analysis of Arm's-Length Royalties for Use of Intangibles 175
a. The Regulations in General 175
b. The Parties' Positions 176
i. Respondent's Position 176
ii. Petitioner's Position 178
c. The Court's Holding as to the Arm's-Length Royalty Rate 183
d. The Offset for the Marketing Commissions Paid by Seagate Singapore to Seagate Scotts Valley 189
2. Analysis of Scope of Ruling 192
VII. ISSUE 7: WHETHER THE PROCUREMENT SERVICES FEES SEAGATE SINGAPORE PAID SEAGATE SCOTTS VALLEY WERE ARM'S LENGTH 201
A. FINDINGS OF FACT 201
1. Background 201
a. The Services Agreement 201
b.
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