84 T.C. 996 (1985)
ELI LILLY and COMPANY and SUBSIDIARIES, Petitioners
COMMISSIONER OF INTERNAL REVENUE, Respondent
United States Tax Court
May 28, 1985
1. Petitioner is engaged in the manufacture and sale of pharmaceutical products. Petitioner created and patented propoxyphene hydrochloride (Darvon) during the early l950's and propoxyphene napsylate (Darvon-N) during the early l960's, Darvon was first introduced into the United States market in 1957, and was manufactured by petitioner from 1957 to 1966. Darvon-N was not introduced into the United States market until 1971 and was never manufactured by petitioner. In 1965, petitioner organized Lilly P.R. as a wholly owned Puerto Rican subsidiary qualifying for the benefits of sec. 931, I.R.C. 1954. In December 1966, petitioner transferred the Darvon and Darvon-N patents and related manufacturing know-how to Lilly P.R. in a sec. 351, I.R.C. 1954, nonrecognition transaction. After 1966 and throughout the years in issue, Lilly P.R. manufactured Darvon and Darvon-N for sale to petitioner who in turn marketed the products throughout the United States. HELD, Lilly P.R.'s ownership of the manufacturing intangibles is recognized in determining arm's length prices between Lilly P.R. and petitioner. HELD FURTHER, the prices Lilly P.R. charged petitioner caused a distortion of income justifying reallocations.
2. HELD, although reallocations of income were warranted, respondent's adjustments to prices under section 482, which denied Lilly P.R. any income from the manufacturing intangibles, were unreasonable.
3. During 1971 and 1972, Lilly P.R. was the sole manufacturer of Darvon and Darvon-N. These drugs were non-narcotic analgesics which competed in the prescription pain relief market with combinations of codeine with aspirin or acetaminophen. At the end of 1972, the Darvon patent expired and, shortly thereafter, several companies began to compete directly with Darvon by manufacturing and marketing generic propoxyphene hydrochloride products. HELD, arm's length prices determined for 1971 and 1972 under sec. 1.482-2(e)(1)(iii), Income Tax Regs. HELD FURTHER, arm's length prices for 1973 determined under sec. 1.482-2(e)(2), Income Tax Regs.
THOMAS M. HADERLEIN, JOHN C. KLOTSCHE, MICHAEL WARIS, JR., GREGG D. LEMEIN, PAUL J. LINSTROTH, and JAMES M. O'BRIEN, for the
JOEL V. WILLIAMSON, CHARLES S. TRIPLETT, and JOSPEH R. GOEKE, for the respondent.
Respondent determined deficiencies in petitioners' Federal income taxes as follows:
By amendment to his answer, respondent asserted increased deficiencies in the following amounts:
The entire amounts of the deficiencies determined by respondent for 1971 and 1972 are in dispute and petitioners claim refunds for 1971 and 1972 in the amounts of $1,700,038 and $1,697,257, respectively. For 1973, all but $189,048 of the deficiency determined by respondent is in dispute. Pursuant to petitioners' motion, this Court severed from the case all issues other than the propriety of respondent's allocations of gross income under section 482 
from Eli Lilly and Company, Inc. (hereinafter ‘ Lilly P.R. ‘ ) to petitioner Eli Lilly Company (hereinafter ‘ petitioner‘ ) with respect to Darvon (Registered) and Darvon-N (Registered) products. The severed issues were consolidated with docket No. 19606-80 for purposes of trial, briefing, and opinion; consequently, a final decision as to the income tax deficiencies of petitioners for the taxable years 1971, 1972, and 1973 will not be possible based upon the opinion of this case. The section 482 allocations of gross income from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products determined by respondent in his notice of deficiency and amendment to answer are as follows:
|| to answer
These allocations raise the following questions for our consideration: 1. Whether petitioner's 1966 transfer pursuant to section 351 of certain Darvon and Darvon-N income producing intangibles to Lilly P.R., a wholly owned subsidiary corporation Page 1002
engaged in manufacturing in Puerto Rico and qualifying as a possessions corporation within the meaning of section 931, should be recognized for the purposes of determining arm's length prices for Darvon and Darvon-N products purchased by petitioner from Lilly P.R. during 1971, 1972, and 1973; 2. Whether respondent's determinations that gross income should be allocated from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products for the years 1971, 1972, and 1973 were arbitrary, capricious, or unreasonable; 3. Whether Lilly P.R.'s prices to petitioner for Darvon and Darvon-N products manufactured by Lilly P.R. and sold to petitioner during 1971, 1972, and 1973 were prices at which those products would have been sold between unrelated parties dealing at arm's length. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. I. HISTORY AND BACKGROUND OF ELI LILLY AND COMPANY A. PETITIONER Petitioner is an Indiana corporation whose principal place of business at the time of filing the petition herein was Indianapolis, Indiana. During the years 1971, 1972, and 1973, petitioner and its consolidated subsidiaries maintained their books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Petitioner and its consolidated subsidiaries filed consolidated Federal income tax returns on Forms 1120 for the taxable years 1971, 1972, and 1973 at the Memphis Service Center, Memphis, Tennessee. Petitioner is engaged in the United States in the invention, development, manufacture, marketing, and sale of a wide variety of ethical (i.e., prescriptions) and other pharmaceutical products, as well as certain agricultural, chemical, and cosmetic products. Petitioner is engaged in similar activities in approximately 145 countries throughout the world through a network of approximately 70 partially and wholly owned domestic and foreign corporations. During the time period Page 1003
1960 through 1975, petitioner and its subsidiaries employed from 10,000 to 24,000 individuals. During the years 1971 through 1973, the relevant divisions and subsidiaries of petitioner and their respective responsibilities were as follows: (a) Pharmaceutical Division: Marketing and sale of pharmaceutical products in the United States. (b) Elanco Products Company: Marketing and sale of animal health and agricultural products in the United States. (c) Elizabeth Arden, Inc.: Marketing and sale of cosmetic products in the United States. (d) Lilly Research Laboratories: Fundamental and developmental research in the life sciences. (e) Production Operations Division: Operation of all manufacturing facilities in the United States. (f) Lilly P.R.: Manufacture and sale of ethical pharmaceutical products in Puerto Rico. (g) Lilly Industries Limited: Fundamental and developmental research in the life sciences and manufacturing, marketing, and sale of pharmaceutical, animal health, and agricultural products. (h) Eli Lilly S.A., Geneva: International marketing, licensing, and holding company. The consolidated net sales (excluding intercompany sales) of petitioner and its worldwide subsidiaries and the United States pharmaceutical net sales of petitioner for the years 1965 through 1973 were as follows (000's omitted):
|| U.S. pharmaceutical
During the years 1971 through 1973, approximately 60 percent of the consolidated sales of petitioner and its worldwide subsidiaries was attributable to the sale of pharmaceutical Page 1004
During those years, petitioner marketed approximately 750 pharmaceutical products in the United States. Petitioner's pharmaceutical sales during that time accounted for approximately 7.5 percent of the total pharmaceutical industry sales in the United States, and its pharmaceutical products accounted for approximately 6.5 percent of the new and refilled prescriptions written in the United States. B. LILLY P.R. Lilly P.R. was organized under the laws of the State of Indiana on June 9, 1965, as a wholly owned subsidiary corporation of petitioner. Lilly P.R.'s principal place of business is located in the Commonwealth of Puerto Rico. During 1971, 1972, and 1973, Lilly P.R. maintained its books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Lilly P.R. filed Federal income tax returns on Forms 1120 for the taxable years 1971 through 1973 with the Office of International Operations, Philadelphia, Pennsylvania. Lilly P.R. was organized by petitioner, among other reasons, to take advantage of the benefits provided by section 931 relating to income from sources within possessions of the United States. Since its inception, Lilly P.R. has been engaged in the manufacture of propoxyphene and other pharmaceutical products in the Commonwealth of Puerto Rico. During each of the years in issue, Lilly P.R.'s gross income satisfied the conditions set forth in subsections (1) and (2) of section 931(a). II. HISTORY AND BACKGROUND OF DARVON AND DARVON-N PRODUCTS A. PROPOXYPHENE AND PROPOXYPHENE HYDROCHLORIDE The search for a nonaddictive synthetic analgesic having the pain relieving properties of morphine began in the late l920's and was accelerated in later years by two...