88 T.C. 252 (1987)
G. D. SEARLE & CO. AND SUBSIDIARIES, Petitioners
COMMISSIONER OF REVENUE, Respondent
Dkt. No. 12836-79
United States Tax Court
February 4, 1987
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 January 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 section 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 section 351, I.R.C. 1954, nonrecognition transactions. During 1969-1971, 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 September 1, 1970, and was paid a fee computed on the basis of 25 percent of SCO's net United States sales. During those years, approximately 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 vendors. 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 United States sales.
In the notice of deficiency, respondent disregarded SCO's ownership of the intangibles and allocated, pursuant to section 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, Julian D. Nihill, Kim E. Cook and Jane Panethiere, for the petitioners.
Joel V. Williamson, Charles S. Triplett, and Joseph R. Goeke, for the respondent.
Respondent determined deficiencies in petitioners' consolidated corporate Federal income tax as follows:
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
of gross income and related business expense deductions from Searle & Co. (hereinafter ‘ SCO‘ ) to petitioner G. D. Searle & Co. (hereinafter ‘ petitioner‘ ). 
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:
| Gross income
| Related business expense deductions
| Net income
These gross income adjustments determined by 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 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. 
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. 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 Page 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., non- prescription) 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 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 United States pharmaceutical sales (including intercompany sales) of petitioner for the years 1960 through 1975 were as follows (000's omitted):
|| Consolidated sales
|| U.S. pharmaceutical sales
FN 1 During 1969 and part of 1970, SCO sold all its pharmaceutical products to petitioner for resale to unrelated parties. FN2 These amounts include resales by petitioner of products purchased from SCO. 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 Operation, 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 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 1950s. The spironolactonepatent (No. 3,013,012) was obtained by petitioner on December 22, 1961. For a period of 17 years following the issuance of United States patent number 3,013,012, including during the years 1974 and 1975, United States 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 Page 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 Company (hereinafter ‘ Ciba‘ ), during the late 1950s and patented by Ciba on December 29, 1964. Petitioner registered the trademarks Aldactone and Aldactazide on April 4, 1960 and...