96 T.C. 226 (1991), 26230-83, Sundstrand Corporation & Subsidiaries v. C.I.R.

Docket Nº:26230-83.
Citation:96 T.C. 226
Opinion Judge:HAMBLEN, JUDGE:
Attorney:John C. Klotsche, Michael Waris, Jr., James M. O'Brien, Mark A. Oates, Bertrand M. Harding, Jr., Robert H. Albaral, and Neil D. Traubenberg, for the petitioner. Reid M. Huey, Joel D. Arnold, Elaine H. Geer, and David L. Zoss, for the respondent.
Case Date:February 19, 1991
Court:United States Tax Court

Page 226

96 T.C. 226 (1991)




No. 26230-83.

United States Tax Court

February 19, 1991

During 1977 and 1978, petitioner and its subsidiaries manufactured and sold numerous products, including the constant speed drive (CSD), an extremely complex avionic device used to drive an airplane engine's generator at a constant speed regardless of the speed of the engine. In 1974, petitioner decided to expand the operations at SunPac, petitioner's wholly owned foreign subsidiary located in the Republic of Singapore, to include the production of CSD's. Pursuant to a license agreement entered into in July 1975, petitioner gave SunPac the exclusive right to use petitioner's industrial property rights for the manufacture of certain CSD spare parts in Singapore; the nonexclusive right to sell the spare parts anywhere in the world; the nonexclusive right for SunPac or its customers to use the parts anywhere in the world; the right for SunPac to subcontract in Singapore to third parties the partial manufacture of the spare parts; and the authorization for SunPac's use of petitioner's trademarks which petitioner normally used in the sale of similar products. Petitioner also agreed to furnish copies of the existing industrial property rights petitioner used in the manufacture of the products and to give SunPac reasonable technical assistance for the startup of SunPac's manufacture of the spare parts. SunPac agreed to pay to petitioner for these rights and for the assistance rendered to SunPac a royalty of two percent of the net selling price of each spare part manufactured and sold by SunPac. Petitioner purchased all of SunPac's output through 1978 at petitioner's catalog price less a 15-percent discount pursuant to a distributor agreement petitioner and SunPac entered into in 1976. Held, respondent abused his discretion under sec. 482, I.R.C. 1954, when he determined that SunPac acted as a subcontractor of petitioner. HELD FURTHER, the royalty contained in the license agreement did not constitute an arm's-length consideration for the use by SunPac of petitioner's intangibles, and the transfer price of petitioner's catalog price less a 15- percent discount did not constitute an arm's-length consideration for the SunPac parts petitioner purchased from Sunpac. However, respondent's sec. 482 adjustments were unreasonable. Sec. 1.482-2(b), (d), and (e), Income Tax Regs., applied to determine the proper sec. 482 adjustments. HELD FURTHER, petitioner is entitled to claim foreign tax credits for 1977 and 1978 applicable to Singapore income taxes paid on the royalty payments SunPac made to petitioner for those years. HELD FURTHER, petitioner is not subject to increased interest under sec. 6621(c).

I. Background 233
A. In General 233
B. The CSD 235
1. Operation 236
2. Marketing CSD's 238
3. Pricing CSD's 238
C. Spare Units and Spare Parts 240
1. Sales 240
2. Pricing 240
a. Spare units 240
b. Spare parts 241
II. The Startup of CSD Operations at SunPac 247
A. Background 241
B. SunPac Parts Selection 245
C. Phasing In the SunPac CSD Operations 247
D. Financing SunPac 248
1. Loans 248
2. Training Grants 249
III. Constructing, Equipping, and Staffing the Facility 249
A. The Land 249
B. The Equipment 250
1. Equipment Transferred from Petitioner 250
2. Equipment Purchased 251
C. Staffing the Facility and Training the Employees 251
IV. The Bedok Facility 252
A. Organization 253
1. The Manufacturing Department 253
2. The Manufacturing Engineering Department 254
3. The Quality Assurance Department 254
4. The Production Planning Department 254
5. The Products Support Department 255
B. Materials Purchases 255
V. Application for Tax Relief 256
A. Relief Available 256
1. Pioneer Certificate 256
2. Expansion Certificate 256
3. Export Enterprise Certificate 257
B. SunPac's Applications for Tax Relief 257
VI. Parts Manufacturer Approval 260
A. In General 260
B. SunPac's Application for PMA 261
VII. The Technical Assistance and License Agreement 264
A. The SunPac License Agreement 264
B. Amendments to the SunPac License Agreement 266
1. Amendments Nos. 1 through 10 266
2. Amendments No. 11 266
C. Payments Under the SunPac License Agreement 269
D. Operations Under the SunPac License Agreement 270
VIII. The Distributor Agreement 271
A. Terms of the Distributor Agreement 271
B. Relationship to U.S. Customs Valuation 272
C. Market for SunPac Parts 276
D. Sales of SunPac Parts 277
IX. Lucas Transactions 279
A. License Agreements 280
1. The 1953 General License 280
2. Amendments to the 1953 General License 282
a. The 1960 amendment 282
b. The 1962 amendment 282
c. The 1964 amendment 282
3. The 1966 General License 284
4. Amendments to the 1966 General License 285
a. The first 1968 amendment 285
b. The TU-144 amendments 285
5. The 1970 Licenses 286
a. The 1970 general license 286
b. The 1970 MRCA license 288
c. The 1970 Concorde license 289
d. The 1970 TU-144 license 289
6. Other Lucas Licenses 290
a. The 1977 traction drive license 290
b. The 1977 PRC license 291
B. Sales Agreements 292
1. The 1962 Sales Agreement 292
2. The 1968 Sales Agreement 292
C. Lucas Operations Under the Licenses 293
X. Other License Transactions 294
A. The Teijin License 294
B. The Siemens License 296
C. The IAI License 297
D. The Licensintorg License 299
XI. The Consignment Agreement 300
B. The Agreement 301
C. SABENA's Expenses and Operations Under the Consignment Agreement 303
1. Expenses 303
2. Operations 303
D. Petitioner's World Market After Entering into the Consignment Agreement 304
XII. Other Sales/Distribution Agreements 304
A. Nissho 304
B. Mikuni 305
C. Other Pesco Products Agreements 306
1. Avio-Diepen 306
2. Standard Aircraft 306
3. Hawker De Havilland 307
4. Secondo Mona 308
5. Pierburg 308
D. Mitsubishi Shoji 308
XIII. Respondent's Adjustments 309
A. The Pricing Issue 309
1. The International Examiner's Report 309
2. The Economist's Report 312
B. The Foreign Tax Credit Issue 314
C. The Notice of Deficiency 314
1. The Transfer Pricing Issue 314
2. The Foreign Tax Credit Issue 315
XIV. The Pleadings 315
XV. Petitioner's Expert Testimony 315
A. Petitioner's Accounting Expert Evidence 315
1. Scrap and Rework Costs 316
2. Finished Process Costs on Semifinished Parts 317
3. Spare Parts Sales History 317
4. Aging of SunPac's Inventory 317
5. Inventory Turnover 318
6. Recording of Inventory Purchases 318
B. Petitioner's Location Savings Expert Testimony 319
1. Methodology 320
2. Savings 321
a. Labor 321
b. Property taxes 323
c. Training costs 324
d. Cost of capital 324
3. Dissavings 328
a. Duty and freight 328
b. Utilities 329
c. State income taxes 330
d. Technical assistance costs 330
C. Petitioner's Economic Expert Testimony 330
1. In General 330
2. Distributor Agreement/Consignment Agreement Comparison 331
3. The 1970 Concorde License 332
4. Costs For Defective and Unfinished Parts and Technical Assistance 333
5. Net Result 334
6. Analysis of Marek Report 334
D. Petitioner's Expert Testimony on the Foreign Tax Credit Issue 334
XVI. Respondent's Expert Testimony 335
A. Pricing Issue 335
1. Differences in Petitioner's Margins for Parts Obtained from SunPac v. Parts Obtained from Non-SunPac Sources 336
2. Differences in Petitioner's Margins for Parts Purchased from SunPac v. Parts Purchased from Comparable Third-Party Manufacturers 337
3. Margin Differences: SunPac v. Comparable Manufacturers 338
4. Return on Capital Assets: SunPac's Rate of Return v. the Competitive Rate of Return 340
B. Location Savings 342
I. Objections to Certain Documents 344
II. Objections to Certain of Respondents's Proposed Findings of Fact Containing Data Summaries 344
III. Objections to New Legal Theories Raised on Brief 346
A. Respondent's New " Services" Theory 346
B. Petitioner's Estoppel Argument 349
C. Other New Arguments 349
I. The Section 482 Adjustments Issue 352
A. In General 352
B. Transfer Price Determination 358
1. The Consignment Agreement as a Comparable Uncontrolled Sale 361
2. The Cost-Plus Method 366
3. The Four Methods Proposed by Dr. Lynk 370
4. The Court's Determination of the Arm's-Length Consideration for the SunPac Parts 374
C. Royalty Income Determination 378
1. The Sunset Royalty Provisions in the Lucas 1970 General License or the Teijin License 383
2. The 1970 Concorde License Royalty 387

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