Eli Lilly & Co. v. C.I.R.

• Decision Date: 27 October 1988
• Docket Number: Nos. 86-2911,86-3116,s. 86-2911
• Citation: 856 F.2d 855
• Parties: -5569, 88-2 USTC P 9502 ELI LILLY & COMPANY and Subsidiaries, Petitioners-Appellants, Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee, Cross-Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 855

856 F.2d 855

62 A.F.T.R.2d 88-5569, 88-2 USTC P 9502

ELI LILLY & COMPANY and Subsidiaries Petitioners-Appellants, Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee Cross-Appellant.

Nos. 86-2911, 86-3116.

United States Court of Appeals, Seventh Circuit.

Argued Dec. 1, 1987.

Decided Aug. 31, 1988.

As Modified Oct. 27, 1988.

Thomas M. Haderlein, Baker & McKenzie, Chicago, Ill., for petitioners-appellants/cross-appellees.

Teresa E. McLaughlin, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee/cross-appellant.

Before WOOD, Jr. and CUDAHY, Circuit Judges, and WILL, Senior District Judge. ^*

CUDAHY, Circuit Judge.

In 1976, the Commissioner of Internal Revenue ("the Commissioner") served a notice of deficiency on Eli Lilly and Company ("Lilly") assessing tax deficiencies against Lilly for the years 1971 through 1973. The bulk of the disputed total amount, roughly $34 million under the Commissioner's revised calculations, derives from the Commissioner's reallocation of income to Lilly from Lilly's subsidiary Eli Lilly and Company, Inc. ("Lilly P.R."). Lilly P.R. manufactured prescription drugs for Lilly in Puerto Rico taking advantage of tax incentives provided by federal and Puerto Rican law. Lilly purchased these drugs from its subsidiary and resold them to American wholesalers. The Commissioner argued that Lilly's transfer of patents and manufacturing know-how to Lilly P.R. in exchange for stock in the subsidiary did not entitle Lilly to allocate the income derived from those assets to Lilly P.R.

Lilly filed a petition with the Tax Court seeking redetermination of the alleged deficiencies. The Tax Court held that Lilly's transfer of intangible assets for stock was valid in principle and that the income from these assets could properly accrue to Lilly P.R. The Tax Court also held, however, that Lilly had transferred the assets to Lilly P.R. for less than arm's length consideration and shifted income to Lilly P.R. through various distortions in the pricing of Lilly P.R.'s output. Making its own income allocations under section 482 of the Internal Revenue Code, the Tax Court increased Lilly's share of the earnings on the drugs manufactured by Lilly P.R. (Darvon and Darvon-N products) by adjusting the prices that Lilly P.R. charged to Lilly. The Tax Court's decision effectively upheld roughly half of the Commissioner's deficiency determination.

Lilly appeals from the Tax Court's adjustment of the transfer prices; the Commissioner cross-appeals from the Tax Court's determination that returns on the patents and manufacturing know-how are allocable to Lilly P.R. We affirm in part, reverse in part and remand.

I. Background

The Tax Court devoted the first 112 pages of its 196-page opinion to a summary of the facts in this case. See Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985). Neither party alleges error in this portion of the Tax Court opinion. We confine our summary to the bare essentials and refer readers seeking greater detail to the Tax Court's able efforts.

Lilly obtained a patent for propoxyphene hydrochloride, the active ingredient of Darvon, in December 1955, and began marketing the product in 1957. In late 1962, the company obtained a patent on a related substance, propoxyphene napsylate, which it sold in the United States as the key ingredient of Darvon-N products beginning in 1971. Because these products filled a need for non-addictive pain relievers acting on the central nervous system, they proved extremely profitable to Lilly, generating $30.2 million in pre-tax net income in 1965.

In 1965 Lilly created Lilly P.R. to manufacture Darvon and Darvon-N products (hereinafter referred to simply as "Darvon products") in Puerto Rico. The Tax Court found that this move was motivated by a variety of factors, important among which were tax incentives provided under Puerto Rican law and section 931 of the Internal Revenue Code, ¹ and Lilly's desire to expand and diversify its manufacturing base. 84 T.C. at 1018-19. In late 1966, Lilly transferred ownership of its two propoxyphene patents along with proprietary information on manufacturing processes to Lilly P.R. in exchange for stock in the subsidiary. Proceeding under the terms of a private letter ruling from the Internal Revenue Service, Lilly claimed nonrecognition treatment for the transfer under section 351. ² From the time it commenced manufacturing operations, Lilly P.R. was the only manufacturer of propoxyphene products in the United States or Puerto Rico.

During the tax years at issue, 1971 through 1973, Lilly P.R. manufactured finished Darvon products using raw ingredients purchased mainly from outside sources. Lilly provided certain specialized services, including engineering, quality control and research and development aimed at developing new propoxyphene products, for which Lilly P.R. paid set fees. Lilly P.R. sold its entire output of Darvon products to Lilly at prices calculated to achieve a proper division of earnings (net of costs) between parent and subsidiary. Lilly's approach to this problem begins, in essence, with four major categories of Darvon earnings: Lilly's return on its marketing activities, Lilly P.R.'s return on its manufacturing activities (including an adjustment for cost savings achieved by operating in Puerto Rico), Lilly's return on marketing intangibles (such as its trademark and good will) and Lilly P.R.'s return on manufacturing intangibles. Lilly first identified "normal" rates of return on marketing and manufacturing activities and computed appropriate returns for Lilly and Lilly P.R. based on these rates; remaining Darvon earnings were then allocated between manufacturing and marketing intangibles. To determine the proper division for the years 1971 through 1973, Lilly relied on a formula that Lilly and the IRS had used to settle a dispute over Lilly's taxes for 1968. ³ Under the formula, Lilly P.R.'s return with respect to its manufacturing activities was set at 100% of its manufacturing costs (cost of goods sold), minus its operating expenses (research and development specific to Darvon products, general administration and sample expenses), plus its location savings (cost savings of operating in Puerto Rico). Lilly's normal return with respect to marketing activities was set at 25% of Darvon-related distribution expenses. Remaining earnings were treated as returns on intangibles. For 1971 and 1972, Lilly P.R. claimed 60% of the returns to intangibles and Lilly 40%; in 1973, Lilly P.R.'s share of returns to intangible assets was reduced to 30% to reflect the drop in the value of the manufacturing intangibles caused by the expiration of the Darvon patent.

The Notice of Deficiency contended that the Commissioner could ignore Lilly P.R.'s nominal ownership of the manufacturing intangibles for purposes of allocating income under section 482 of the Internal Revenue Code. The Tax Court rejected the view that Lilly P.R.'s ownership could be disregarded in its entirety, but held that the transfer of the manufacturing intangibles was not an arm's length transaction and that section 482 could be used to achieve a division of Darvon earnings more nearly approximating the division that an arm's length transaction would have produced. Specifically, the Tax Court objected to the transfer of the manufacturing intangibles on the grounds that in an arm's length exchange Lilly would have insisted on some form of lump sum or periodic cash payments to help meet the costs of its general research and development activities. In addition, the Tax Court reviewed the Darvon transfer prices themselves and found independent grounds for invoking section 482. The Tax Court corrected the perceived distortion of Lilly's income by reducing Lilly P.R.'s prices to Lilly, thereby increasing Lilly's share of the Darvon profits.

Both Lilly's appeal and the Commissioner's cross-appeal dispute the Tax Court's application of section 482 to the Darvon profits. The Commissioner contends that the Tax Court adopted an overly restrictive view of the Commissioner's authority under section 482 by holding that the transfer of intangible rights to an offshore subsidiary in exchange for stock must be accepted, in principle, as a valid arm's length transaction. Lilly contends that the Tax Court arrogated too much authority to itself by reallocating earnings between parent and subsidiary based on an unsupported rejection of the taxpayer's own efforts to establish arm's length transfer prices for the Darvon products. We consider the Commissioner's challenge first.

II. The Applicability of Section 482

Section 482 confers broad authority on the Commissioner to allocate income or deductions among commonly controlled entities where "such ... allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." ⁴ Citing section 1.482-1(c) of the regulations applicable during the period in question, the Commissioner claims a general mandate to adjust incomes wherever the income of a controlled taxpayer "either by inadvertence or design ... is other than it would have been had the taxpayer in the conduct of his affairs been an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer." Treas.Reg. Sec. 1.482-1(c) (1986). More specifically, the Commissioner relies on the regulations' assertion of authority to reallocate income between related parties even where such reallocations effectively nullify nonrecognition transactions authorized by other sections of the Internal Revenue Code, such as section 351. See 26 Treas.Reg. Sec. 1.482-1(d)(5) (1986). ⁵ Examining Lilly's transfer of patents and manufacturing know-how to Lilly P.R. under these authorities, the Commissioner concluded that an arm's length deal between Lilly and Lilly P.R. would have limited Lilly P.R. to a reasonable return on its manufacturing...