Eli Lilly and Company v. United States

• Decision Date: 17 February 1967
• Docket Number: No. 293-61.,293-61.
• Citation: 372 F.2d 990
• Parties: ELI LILLY AND COMPANY v. The UNITED STATES.
• Court: U.S. Claims Court

372 F.2d 990 (1967)

ELI LILLY AND COMPANY v. The UNITED STATES.

No. 293-61.

United States Court of Claims.

February 17, 1967.

COPYRIGHT MATERIAL OMITTED

Thomas M. Haderlein, Chicago, Ill., for plaintiff. Walter A. Slowinski, Washington, D. C., attorney of record. Russell Baker, Chicago, Ill., Michael Waris, Jr., Washington, D. C., and Baker, McKenzie & Hightower, Chicago, Ill., of counsel.

Cynthia Holcomb, Washington, D. C., with whom was Asst. Atty. Gen., Mitchell Rogovin, for defendant. Lyle M. Turner and Philip R. Miller, Washington, D. C., of counsel.

Before COWEN, Chief Judge, and LARAMORE, DURFEE, DAVIS, COLLINS, SKELTON and NICHOLS, Judges.

OPINION

PER CURIAM:

This case was referred to Trial Commissioner Lloyd Fletcher with directions to make findings of fact and recommendation for conclusions of law. The commissioner has done so in an opinion and report filed on September 20, 1965. Exceptions to the commissioner's report, findings and recommended conclusion of law were filed by plaintiff and defendant excepted to a statement in the commissioner's opinion. The case has been submitted to the court on oral argument of counsel and the briefs of the parties. Since the court is in agreement with the opinion, findings and recommendation of the commissioner, with modifications, it hereby adopts the same, as modified, as the basis for its judgment in this case, as hereinafter set forth. Plaintiff is therefore not entitled to recover and the petition is dismissed on its petition filed on July 26, 1961, and the case is remanded to the trial commissioner for further proceedings on plaintiff's motion to amend the petition.

Commissioner Fletcher's opinion, as modified by the court,^* is as follows:

It has been said that:

Of all the areas of executive decision, pricing is perhaps the most fuzzy. Whenever a price problem is discussed * * *, divergent figures are likely to be recommended without a semblance of consensus. Oxenfeldt, Multistage Approach to Pricing, 38 Harv. Bus.Review 125 (July, August 1960)

This novel and difficult case presents a study in that "fuzzy" area of pricing. The taxpayer, hereinafter referred to as "Eli Lilly," has adopted a pricing policy on its products destined for international markets which results in its selling organizations receiving the bulk of the overall profits from sales abroad. That policy disturbs the Government only insofar as it involves Eli Lilly's products sold in the Western Hemisphere (other than the United States). Because one of Eli Lilly's selling subsidiaries qualifies as a Western Hemisphere trade corporation, and therefore enjoys a reduced rate of tax on its income, the Government asserts that Eli Lilly's pricing policy results in tax avoidance and does not clearly reflect the incomes of the related organizations. Accordingly, the Government has endeavored to counter Eli Lilly's pricing policy by making use of a relatively compact section of the Internal Revenue Code of 1954 containing words of delusive simplicity. It reads in its entirety as follows:

§ 482. Allocation of income and deductions among taxpayers.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses. (26 U.S.C. 1958 ed., Sec. 482)¹

Before describing the manner in which the Commissioner of Internal Revenue has allocated income between Eli Lilly and its subsidiaries, it is necessary to review briefly the history and development of Eli Lilly's international trade including a description of the methods adopted by the company for conducting such foreign business during the years at issue, 1952 through 1957.

Eli Lilly is an Indiana corporation. It is a long-established and well-known manufacturer and seller of pharmaceuticals, biologicals, and related products, including certain agricultural and industrial products of a similar nature.² Prior to 1940, the management of Eli Lilly appears to have given only sporadic attention to the development of a significant international market for Lilly products. During 1940, however, J. K. Lilly, Jr., who was head of domestic marketing, assumed responsibility for export sales also. He initiated studies to determine what could be done to improve Eli Lilly's position in foreign markets. One result was the formation within Eli Lilly of an Eastern Hemisphere sales division and a Western Hemisphere sales division. That method of organization proved unsatisfactory because company personnel continued to devote their major energies to domestic matters and tended to treat the new international divisions as step-children.

By June of 1943, Mr. Lilly had decided that the best way to develop the international market was through subsidiary corporations. Whereupon, Eli Lilly formed under the laws of Indiana two wholly-owned subsidiaries, Eli Lilly International Corporation (International) to service business in the Eastern Hemisphere and Eli Lilly Pan-American Corporation (Pan-American) to service foreign business in the Western Hemisphere.³ Eli Lilly personnel with prior experience in the respective hemispheres were placed in charge of the new corporations.

The matter of pricing Lilly products to the new subsidiaries was then made the subject of extensive consideration. Following discussions and studies of numerous unique factors applying to sales of pharmaceuticals in foreign markets, Eli Lilly's management decided to price its products to International and Pan-American on what is best described as an incentive or motivation basis. A very substantial discount off domestic prices, increasing with volume, was applied to sales to the subsidiaries with the thought that such favorable treatment would be an incentive to expansion and growth of the foreign markets. The original agreements in this respect are more fully described in finding 17.

These original intercompany arrangements were worked out by Eli Lilly's management primarily for what it considered to be sound business reasons. At first, no consideration appears to have been given to the subject of taxes. However, in February 1944, the subject was considered, and an application was made to the Commissioner of Internal Revenue for a ruling as to Pan-American's status under the Western Hemisphere trade corporation provisions of the 1939 Code. Based on the facts submitted, the Commissioner issued a favorable ruling to Pan-American.

No significant change in the above arrangements occurred until 1946. In that year it was decided to change the merchandise flow to foreign markets. Instead of selling directly to its several subsidiaries, Eli Lilly decided to use International as its exclusive distributor for export of its products throughout the world. Under this new arrangement, all merchandise destined for export was purchased from Eli Lilly by International and sold by the latter either to Pan-American, to other subsidiaries, or directly to unrelated wholesalers in the Eastern Hemisphere. The pricing policy adopted on sales to International was a discount of 60 percent from domestic prices on finished and packaged merchandise, and at Eli Lilly's cost plus 15 percent on bulk merchandise.

That pricing policy continued through 1948, when, during an audit of Eli Lilly's tax returns, the Internal Revenue Service first proposed to reallocate income of International and Pan-American to Eli Lilly. This dispute involving earlier years was compromised, and for 1949, 1950, and 1951 Eli Lilly transferred merchandise to International and prepared its tax returns on the basis of that settlement for the earlier years.

In the year 1952 Eli Lilly reexamined its position on pricing to International. It had become apparent that Pan-American and International were finding it difficult to make profits. Prices were demoralized in the antibiotic field and, streptomycin was being purchased by Eli Lilly and sold at a loss because of its difficulties in manufacturing that product. Also, there was a continuing tax problem under section 45 of the 1939 Code (now section 482 of the 1954 Code, supra), and the company's accountants and tax attorneys told management that the existing pricing arrangement flowing from the settlement described above had placed Eli Lilly at a substantial disadvantage taxwise with respect to the rest of the industry. Accordingly, studies were made during the year 1952 and advice was obtained to determine what action should be taken with respect to the transfer price from Eli Lilly to International. This study was participated in by the highest management officials of Eli Lilly. They found that if Eli Lilly continued to price on the basis of the composite average which it had used during the years 1949, 1950, and 1951, resulting from the earlier settlement, International and Pan-American would have operated at losses during the year 1952.

The pricing policy finally established for the year 1952 differed somewhat from the policy which had been used in the years 1944 through 1948. The price arrangement which had been in effect from 1944 through 1948 had been considered in terms of a discount off domestic net trade prices which was the common denominator at that time in maintaining inventory controls. The price which was determined in 1952 was a cost-oriented price which made no provision for a specific monetary profit to Eli Lilly. All sales by Eli Lilly to International under this policy were priced to effect a recovery of the manufacturing cost of goods sold, plus...