                       T.C. Memo. 1999-220



                     UNITED STATES TAX COURT



                   COMPAQ COMPUTER CORPORATION
                 AND SUBSIDIARIES, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 24238-96.              Filed July 2, 1999.



     Mark A. Oates, John M. Peterson, Jr., James M. O'Brien,

Owen P. Martikan, Paul E. Schick, Robert S. Walton, Tamara L.

Frantzen, Erika S. Schechter, A. Duane Webber, David A. Waimon,

Lafayette G. Harter III, and Steven M. Surdell, for petitioner.

     Raymond L. Collins and Todd A. Ludeke, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Chief Judge:    Respondent determined deficiencies and

a penalty in petitioner's Federal income taxes as follows:
                                - 2 -


                                               Penalty
     Taxable Year Ended       Deficiency     Sec. 6662(a)

         Nov. 30, 1991       $42,422,470          --
         Nov. 30, 1992        33,533,968       $547,619

     The issue addressed in this opinion is whether income

relating to printed circuit assemblies (PCA's) should be

reallocated under section 482 to petitioner from its Singapore

subsidiary for its 1991 and 1992 fiscal years.    (A separate

opinion will address issues, previously tried and briefed, of

whether petitioner's purchase and resale of American Depository

Receipts in 1992 lacked economic substance and whether petitioner

is liable for an accuracy-related penalty pursuant to section

6662(a).    Petitioner has also filed a Motion for Summary Judgment

on the issue of whether petitioner is entitled to foreign tax

credits for certain United Kingdom Advance Corporation Tax

payments.)    Unless otherwise indicated, all section references

are to the Internal Revenue Code in effect for the years in

issue.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     Compaq Computer Corporation is a Delaware corporation with

its principal place of business in Houston, Texas.    Compaq

Computer Corporation and subsidiaries filed consolidated Federal

income tax returns for the taxable years ended November 30, 1991,
                               - 3 -


and November 30, 1992.   As used in this opinion, "petitioner"

will refer to Compaq Computer Corporation together with its

subsidiaries.   "Compaq U.S." will refer to the Compaq Computer

Corporation Houston operation that includes the company

headquarters and a manufacturing plant.

Background

     Compaq U.S. was founded in 1982, when a group of former

employees of Texas Instruments designed a portable personal

computer (PC) on a place mat in a restaurant.   Since its

incorporation, Compaq U.S. has been engaged in the business of

designing, manufacturing, and selling PC's, and, by 1994, Compaq

U.S. had become the world's largest manufacturer of PC's.    The

success of Compaq U.S. was primarily attributable to its ability

to bring high-quality products to market quickly.

     At all relevant times, Compaq U.S. manufactured central

processing units (CPU's) for its PC's at Compaq U.S. in Houston,

at Compaq Asia (Pte) Ltd. (Compaq Asia) in Singapore, and at

Compaq Computer Manufacturing Ltd. in Scotland.   The materials

required to manufacture CPU's include PCA's, the electronic

circuitry inside the CPU that allows the PC to operate.     Each PCA

consists of a printed circuit board, the communication platform

to which components are attached, and any number of combinations

of chips, resistors, and capacitors.   These circuits and boards

interconnect to deliver a desired electronic function.
                                 - 4 -


     Compaq U.S. had three sources of PCA's.    Compaq U.S.

manufactured PCA's itself.   In addition, Compaq U.S. purchased

PCA's from Compaq Asia and from various unrelated PCA

subcontractors (unrelated subcontractors) that were primarily

located in the United States.    Approximately half of the Compaq

U.S. 1991 through 1992 PCA requirements were manufactured by

Compaq U.S. or purchased from unrelated subcontractors, and the

other half were manufactured by Compaq Asia.

PCA Technology

     PCA's are characterized by the types of components placed on

the printed circuit board.   Components are attached to the board

through soldering, and components soldered to the surface of the

printed circuit board are known as "surface-mount" (SMT)

components.   Components having leads that are inserted through

holes in the printed circuit board and then soldered to the board

are "through hole" components.    PCA's containing only surface-

mount components are known as SMT PCA's, and PCA's containing

only through hole components are known as "through hole" PCA's.

PCA's that use both through hole and SMT components are known as

"mixed technology" PCA's.

     Although SMT components are generally smaller than their

through hole counterparts, there is no functional difference

between them.    The SMT process, however, is the newer process and

packs components densely on both sides of the printed circuit
                                 - 5 -


board, reducing the size of the PCA by one-third to one-half.

During 1991 and 1992, PCA's rarely had only SMT components

because some components were not available in the surface-mount

format.

     The key feature of size for all components, both SMT and

through hole, is "lead pitch".    Lead pitch is the center-to-

center distance between the adjacent leads that connect

components to the printed circuit board.    For example, the lead

pitch of a through hole component may be 100 mils or one-tenth of

an inch.   By comparison, the lead pitch of a comparable SMT

component is about 50 mils.

     When lead pitch is reduced to 20 or 25 mils, the component

is a "fine pitch" component.    Many Compaq U.S. PCA's had multiple

fine pitch devices on the same board that required significant

process engineering controls, thus increasing the complexity of

the manufacturing process.    The manufacturing process was further

complicated when fine pitch devices were scattered throughout the

board, were placed near the edges of the board, or were placed on

the bottom side of the board.

     SMT manufacturing is capital intensive and works best with

SMT placement equipment featuring "vision" technology.    This

technology has the precise capability to place small SMT

components on the correct electronic connections on each printed

circuit board during the soldering process.    Vision technology
                                - 6 -


incorporates video cameras that examine each chip's and PCA's

rotation and orientation to ensure precise placement.

Compaq U.S. used Fuji placement equipment and generally required

unrelated subcontractors to use the same equipment.    In addition,

SMT manufacturing requires well-trained machine operators to

follow detailed manufacturing procedures and experienced

engineers to supervise and control the manufacturing process.

     Through hole technology is less reliant on manufacturing

equipment.    Accordingly, through hole components may be inserted

manually or by machines, depending upon the number of components

on the PCA.    When there are very few through hole components or

odd-shaped through hole components, the through hole components

are inserted manually.

Compaq U.S. Processes

     Compaq U.S. used many advanced processes in manufacturing

its PCA's.    For example, petitioner developed and used the

"no-clean" process that eliminated the need to clean PCA's after

soldering.    Before developing the no-clean process, Compaq U.S.

had to clean PCA's, removing flux from the printed circuit board.

Flux is a detergent used prior to soldering to remove impurities

from the soldering surfaces and to prepare a clean surface for

joining.   Flux had to be removed after soldering to prevent PCA

corrosion and field failures.    The no-clean process uses less

potent flux that does not cause corrosion or field failures and
                               - 7 -


does not require removal after soldering takes place.    This

process, however, requires a controlled soldering atmosphere and

tight process controls to prevent defects.

     Compaq U.S. also used "paste-in-hole" technology and wave

soldering of bottom-side small outline integrated circuits

(SOIC's).   These processes used different methods of soldering

components to printed circuit boards, adding to the manufacturing

complexity of PCA's used by Compaq U.S. due to the extensive

engineering support and tight manufacturing controls required to

use these processes.

     In addition, Compaq U.S. used U-shaped continuous flow

manufacturing lines rather than the more common "batch

processing".   Continuous flow manufacturing reduces the time

required to manufacture a PCA because a bare printed circuit

board starts at the beginning of a manufacturing line and flows

through the manufacturing process nonstop until both sides of the

board are populated with components and tested for defects.     The

U-shaped lines used by Compaq U.S. and Compaq Asia featured a

layout of lines in a U shape so that testing took place in front

of the beginning of the assembly process.    With short cycle time

and in-circuit testers located in front of the pick-and-place

machines (due to the U shape of the line), process controls and

immediate corrective actions could be implemented based on test

data to ensure quality.   In contrast, the batch processing used
                                - 8 -


by many unrelated subcontractors transfers boards in batches

between machines on the manufacturing floor.      This results in

inventory buildup and increases the defect rate due to reduced

quality controls.

     After assembly, the PCA's are tested to guarantee that the

PCA is functioning properly.    There are two types of tests that

Compaq U.S. performs:    In-circuit tests (ICT) and functional

tests.    The more precise of the two is ICT.    Compaq U.S. uses

GenRad testers and specific test programs to perform ICT's and is

able to pinpoint specific defects.      Functional tests generally

detect whether there are defects in the PCA.      If an error is

found, additional procedures must be performed to locate the

specific error.

     These tests monitor quality by scrutinizing first-pass

yields, the percentage of PCA's that pass tests the first time

tested.    PCA's that pass these tests the first time are

considered to be of higher quality.      A PCA that fails either the

ICT or functional test is repaired or reworked until the PCA

passes the tests and meets the Compaq U.S. quality standards.        If

the PCA cannot be repaired, it is scrapped.      The time and

personnel required to debug and rework a board add to the PCA's

cost and degrade the PCA's quality and reliability.
                               - 9 -


Types of PCA's

     Compaq U.S. segregated PCA purchases into five different

categories of PCA's:   Processors, power supplies, memory boards,

video boards, and a catchall category entitled backplane/other.

At all sites, PCA's within each product category were built using

the same design guidelines, the same workmanship standards, the

same or virtually identical manufacturing equipment, the same

manufacturing process, the same materials purchased from the same

approved vendor list (AVL), and were tested using the same or

virtually identical test equipment and programs.   Within each

category, the only differences in the PCA's were the particular

components used on each individual PCA and the time required to

process the PCA on the manufacturing line.

     With respect to power supplies, the global power supply

market was made up of two distinct market segments--custom power

supplies and commodity power supplies--and the industry generally

acknowledged that commodity power supplies were of lesser quality

with limited functionality.   Power supplies designed by Compaq

U.S. and Compaq Asia fell into the custom power supply market

segment.

Compaq Asia

     In the mid-1980's, Compaq U.S. pursued material cost savings

allegedly available in Asian markets in both PC and PCA

manufacturing.   Specifically, in 1984, petitioner began doing
                              - 10 -


business with Automated Assembly of Singapore (AAS), purchasing

through hole PCA's.   AAS did not, however, meet Compaq U.S.

quality expectations and was not responsive to Compaq U.S.

production demands.   Accordingly, petitioner fired AAS in

February 1985.   Compaq U.S. attempted a similar cost savings

effort in 1984 using Bolnar, an unrelated international

purchasing organization, but this business relationship was also

unsuccessful.

     Based on these two unsuccessful attempts to access lower

material costs, Compaq U.S. opened Compaq Asia in Singapore in

1986.   Compaq Asia was organized under the laws of Singapore and,

during all relevant years, was a wholly controlled subsidiary of

Compaq U.S.   Compaq Asia was primarily a PCA subcontractor,

manufacturing all types of PCA's to Compaq U.S. specifications.

Compaq Asia shipped its first PCA's in 1987 and, overall, was

successful in achieving worldwide material cost savings for

Compaq U.S.

     The Compaq Asia factory was substantially similar to Compaq

U.S. from the architecture of the plant to the makes and models

of the machines on the production floors.   Specifically, Compaq

Asia used the same Fuji vision centering pick-and-place

equipment, GenRad test equipment, screen printers, and reflow

ovens used by Compaq U.S.   In addition, Compaq Asia utilized many

of the same manufacturing processes used by Compaq U.S.,
                              - 11 -


including U-shaped continuous flow manufacturing lines, no-clean,

paste-in-hole, and wave soldering of bottom-side SOIC's.   Compaq

Asia was also responsible for improving designs and manufacturing

processes for all Compaq Asia PCA's and CPU's, including designs

for custom power supplies, and Compaq Asia built PCA's with

multiple fine pitch components that required critical process

controls to reduce rework and maintain quality.

     As with Compaq U.S., the top priority of Compaq Asia was to

produce high-quality products.   Compaq U.S. developed in-house

workmanship standards that specified acceptable and unacceptable

quality of PCA's.   All manufacturing sites, including Compaq Asia

and unrelated subcontractors, were required to comply with these

standards.   To ensure quality, Compaq Asia conducted extensive

in-house training and used statistical process controls to

monitor the processes so Compaq Asia engineers could take quick

corrective actions if necessary.   As a result, Compaq Asia

achieved ICT first-pass yields of 98 percent in 1991 and

97.2 percent in 1992 and functional test first-pass yields of

98.5 percent in 1991 and 98 percent in 1992.

     Compaq Asia was more advanced than other Singaporean PCA

producers that primarily produced PCA's for disk drives and other

small electronic devices, which had few technological,

manufacturing, and process control requirements.   Accordingly,

Compaq Asia did not compete with those companies because those
                              - 12 -


Singaporean subcontractors did not have the technology to

manufacture PCA's to satisfy Compaq U.S. quality expectations.

Standard Costs

     Like most organizations that produce a large number of

individual products using processes that are both complex and

relatively standardized, during the years in issue, Compaq U.S.

and Compaq Asia tracked their manufacturing costs using a

standard cost system that assigned specific costs to arrive at a

material standard, a labor standard, and an overhead standard.

The standard material costs for Compaq U.S. and Compaq Asia were

estimates of future costs expected to be paid for materials from

vendors on the Compaq U.S. AVL.   The standard labor and overhead

costs for Compaq U.S. were based on forecasted production in the

Houston facility.   The standard labor and overhead costs for

Compaq Asia were based on forecasted production in the Singapore

facility.   The standard costs for material, labor, and overhead

for Compaq Asia were generally lower than the same standard costs

for Compaq U.S.

Transfer Prices

     Purchases from Compaq Asia satisfied approximately one-half

of the PCA needs of Compaq U.S. from 1990 to 1993.   During that

time, Compaq U.S. purchased the following amounts of PCA's from

Compaq Asia:
                                               - 13 -


                     Power                         Memory                       Backplane/
                    Supplies      Processors       Boards        Video Boards     Other          Total

       1991

Unit sales           1,065,966        382,286        30,191            74,090      180,611      1,733,144

Compaq Asia PCA    $143,474,373   $167,151,642    $5,570,843      $11,632,130   $11,919,452   $339,748,440
 shipments ($)

       1992

Unit sales           1,293,140        514,154               0         195,751    1,571,896      3,574,941

Compaq Asia PCA     $94,643,303   $187,135,315              $0    $24,260,291   $73,486,057   $379,524,966
 shipments ($)

    1991-1992

Unit sales           2,359,106        896,440        30,191           269,841    1,752,507      5,308,085

Compaq Asia PCA    $238,117,676   $354,286,957    $5,570,843      $35,892,421   $85,405,509   $719,273,406
  shipments ($)

             Compaq U.S. paid what is recognized in the industry as the

   turnkey price for the PCA's listed above.                        In turnkey

   transactions, unrelated subcontractors purchase materials and

   components from suppliers on the Compaq U.S. AVL, paying the same

   prices as Compaq U.S.          The turnkey price paid by Compaq U.S.

   compensated unrelated subcontractors for materials, labor, and

   overhead as well as a profit markup on each.                         In contrast, Compaq

   U.S. purchased other PCA's on a consignment basis.                            In

   consignment transactions, Compaq U.S. consigned raw materials and

   components to the subcontractor, and the consignment price paid

   by Compaq U.S. compensated unrelated subcontractors for their

   labor and overhead costs plus a profit on the labor and overhead.

             Because there was stiff competition from unrelated

   subcontractors for most PCA's, prices were set at levels allowed

   by the market.        The prices for Compaq Asia PCA's were set
                              - 14 -


semiannually by the Compaq U.S. tax department and were based on

Compaq U.S. standard manufacturing costs that Compaq U.S. used as

a benchmark for purchasing PCA's from unrelated subcontractors.

The prices did not, however, include compensation for overtime,

rework performed, changes in material prices, changes in the

delivery schedule, material cancellation costs, inventory

shrinkage, production scrap, setup charges, or obsolete

inventory.

     Specifically, in 1991 and 1992, the transfer prices for

Compaq Asia PCA's were set using a cost-plus formula, pursuant to

section 1.482-2A(e)(1), Income Tax Regs.   The formula was Compaq

U.S. labor and overhead costs minus Compaq U.S. overhead costs

that would continue to be incurred by Compaq U.S. despite

manufacture of PCA's at Compaq Asia (Compaq U.S. fixed overhead

costs) multiplied by 1.15 plus Compaq U.S. material costs.

Compaq Asia costs were not used as part of the transfer price

analysis.

     In 1992, the formula was amended, and Compaq Asia material,

labor, and overhead costs were multiplied by 1.3, plus a total

location savings times .3.   The total location savings was

calculated by subtracting Compaq Asia material, labor, and

overhead costs and Compaq U.S. fixed overhead costs from Compaq

U.S. standard material, labor, and overhead costs.
                                               - 15 -


          Compaq Asia sales to Compaq U.S. during 1991 and 1992 were

   101.5 and 88.1 percent of Compaq U.S. standard cost to produce

   the PCA's, respectively.               On an aggregate basis, Compaq Asia sold

   PCA's to Compaq U.S. at an average transfer price that was equal

   to 93.9 percent of Compaq U.S. standard costs for 1991 and 1992.

   The following table breaks down the PCA's into separate

   categories and compares Compaq Asia prices to Compaq U.S.

   standard cost during 1991 and 1992:

                        Power                        Memory                     Backplane/
                       Supplies      Processors      Boards      Video Boards     Other          Total

Compaq Asia PCA          2,359,106        896,440       30,191        269,841     1,752,507      5,308,085
 shipments (units)

Compaq Asia PCA       $238,117,676   $354,286,957   $5,570,843   $35,892,421    $85,405,509   $719,273,406
 shipments ($)

Compaq US std. cost   $283,325,817   $350,280,911   $5,456,326    $36,505,921   $90,134,571   $765,703,546

Compaq Asia price            84.0%         101.1%       102.1%          98.3%         94.8%          93.9%
 as % of Compaq US
 std. cost


   Unrelated Subcontractors

          In addition to making purchases from Compaq Asia, Compaq

   U.S. also purchased PCA's from unrelated subcontractors during

   1990 to 1993 and had used unrelated subcontractors as a source of

   PCA's since 1983.              Compaq U.S. maintained this ongoing

   relationship with its unrelated subcontractors so it would be

   able to respond to market demands when necessary, bringing

   products to market as quickly as possible.                        Compaq U.S. also used

   the prices that were paid to the unrelated subcontractors as a

   benchmark for its standard manufacturing costs.
                               - 16 -


     In evaluating potential subcontractors, Compaq U.S. required

subcontractors to have significant manufacturing experience,

financial stability, competent management, and strong

engineering.   Compaq U.S. developed the World Class Supplier

Process Survey (the WCSP) to evaluate new subcontractors and to

provide feedback to existing subcontractors.    This survey takes

into consideration quality system management, documentation,

procurement, manufacturing and material control, final

acceptance, calibration, quality information, and statistical

process control.    The Compaq U.S. Commodity Management Team (CMT)

was responsible for administering the WCSP and evaluating PCA

subcontractors.    In selecting subcontractors, the CMT chose

subcontractors to complete the WCSP, and, from this information,

the CMT picked which subcontractors to visit and evaluate.

     Compaq U.S. preferred that unrelated subcontractors use the

same Fuji manufacturing equipment, GenRad test equipment, and

programs in their manufacturing process that Compaq U.S. used in

manufacturing PCA's.    This allowed Compaq U.S. to provide

customer support to its unrelated subcontractors and to

troubleshoot a problem because it was familiar with the

equipment.   In addition, the same equipment allows the unrelated

subcontractors to use the same programs.    Compaq U.S. also

preferred its subcontractors to use the continuous flow rather

than the batch manufacturing process, although most
                               - 17 -


subcontractors operated in batch mode from 1990 to 1993.

Compaq U.S. required unrelated subcontractors to meet Compaq U.S.

quality standards and guidelines in manufacturing PCA's.

     Compaq U.S. worked closely with unrelated subcontractors to

develop relationships that would improve quality and on-time

delivery.   In addition, members of the CMT visited the

subcontractors or the subcontractors visited Compaq U.S. for

training, new product introduction, and problem resolution.

     In 1991 and 1992, competition among unrelated subcontractors

for PCA business was intense and was driven by technology,

quality, service, price, and the ability to deliver on time.      The

competition was also global in scope as the Compaq U.S. unrelated

subcontractors that were located in the United States not only

competed against each other but also competed against Far East

subcontractors, including Compaq Asia.

     Compaq U.S. purchases from unrelated subcontractors were

primarily on a consignment arrangement.   The unrelated

subcontractors with which Compaq U.S. did business were as

follows:    IEC; SCI Manufacturing, Inc. (SCI); Philips Circuit

Assemblies, Inc. (Philips); Victron, Inc. (Victron); Lung Hwa

Electronics Company (Lung Hwa); Citizen Watch Co., Ltd.

(Citizen); Avex Electronics, Inc. (Avex); Solectron Corporation

(Solectron); Celestica; GSS/Array Technology, Inc. (GSS/Array);

Texas Instruments, Inc. (Texas Instruments); Jabil Circuit, Inc.
                               - 18 -


(Jabil); Xetel Corporation (Xetel); and Bull HN Information

Systems, Inc. (Bull HN).

     Most of these unrelated subcontractors were located in the

United States; however, there were some exceptions.    Lung Hwa was

a Taiwanese PCA manufacturer from which Compaq U.S. purchased

PCA's from 1990 through 1993, and Solectron had plants in the

United States and Malaysia.    However, the Solectron plant in

Malaysia primarily manufactured simple PCA's for disk drives and

telephone headsets.    The more complex Solectron boards were built

at the Solectron California plant because that plant was more

advanced.

     Most of the unrelated subcontractors that did business with

Compaq U.S. between 1990 and 1993 used the same pick-and-place

equipment and test equipment as Compaq U.S.    There were, however,

some exceptions.   For example, Compaq U.S. tolerated the use by

Philips of non-Fuji equipment because Philips manufactured the

pick-and-place equipment that it used and was capable of

operating and repairing Philips equipment, alleviating potential

production concerns.   Philips, however, later converted to Fuji

placement equipment.   Lung Hwa used Panasert and Xetel used

Panasonic placement equipment rather than Fuji machines, but

Compaq U.S. ultimately terminated its business relationship with

both companies.    Lung Hwa was unable to meet Compaq U.S.

production demands without exceeding quoted prices, and Xetel
                              - 19 -


experienced significant manufacturing and quality problems when

it converted the machines to vision technology.   Compaq U.S. was

unable to provide technical assistance to Xetel because the

machines were not Fuji machines.

     In addition to difficulties with subcontractors having

different machines, Compaq U.S. also experienced difficulty with

subcontractors that used different processes, including Texas

Instruments.   Although Texas Instruments had acceptable quality,

its use of the batch process of manufacturing created some

difficulties in shipping PCA's on time.

     Compaq U.S. purchases from Compaq Asia were nearly identical

to purchases from unrelated subcontractors, but there were some

differences in the transactions between the parties.   For

example, Compaq U.S. incurred additional freight and duty costs

annually when dealing with Compaq Asia in the amounts of

$2.6 million and $1.2 million, respectively.   With respect to

materials, Compaq Asia was responsible for leftover parts while

Compaq U.S. reimbursed unrelated subcontractors for leftover

parts.   In addition, Compaq U.S. paid Compaq Asia in 90.9 days

while unrelated subcontractors were generally paid in 30.3 days.

Another transactional difference was that Compaq U.S. paid for

setup charges in transactions with unrelated subcontractors in

the amount of $2.9 million during 1991 and 1992 while not making

comparable payments to Compaq Asia.
                                - 20 -


     During 1990 through 1993, 93 percent of Compaq U.S.

purchases from unrelated subcontractors were from subcontractors

located in the United States.    Compaq U.S. had some bad

experiences with unrelated subcontractors in foreign countries,

and, when demand for Compaq U.S. products increased in 1992,

Compaq U.S. increased its purchases from unrelated subcontractors

in the United States rather than purchasing from Far East

subcontractors.

Respondent's Audit Determination

     In response to information requests during the audit,

petitioner described its transfer price formula as "a cost plus

formula inclusive of location savings" and stated that the

comparable uncontrolled price method (the CUP method) was not

applicable to petitioner's purchase of PCA's from Compaq Asia.

Respondent adopted a modified cost-plus or profits-based fourth

method pursuant to section 1.482-2A(e)(1)(iii), Income Tax Regs.,

marking up Compaq Asia manufacturing costs by an operating profit

markup of 7.5 percent.   This method was based on the report of

respondent's staff economist, Peter Balash (Balash), and produced

an aggregate price for Compaq Asia PCA's that was $232,402,000

less than the Compaq U.S. 1991 and 1992 combined return

positions.   Accordingly, respondent determined that the prices

that Compaq U.S. paid to Compaq Asia for PCA's during 1991 and
                               - 21 -


1992 did not constitute arm's-length prices.    The notice of

deficiency increased Compaq U.S. income by the following amounts:

          Taxable Year Ended                Amount

              Nov. 30, 1991              $124,482,000
              Nov. 30, 1992                90,370,000

Petitioner's Analysis

     Prior to trial, petitioner abandoned its cost-plus method of

calculating the arm's-length prices for Compaq Asia PCA's and, at

trial, defended the intercompany prices pursuant to the CUP

method based on Compaq U.S. regular and substantial purchases of

identical or nearly identical PCA's from uncontrolled

subcontractors.

     To support its position at trial of this case, Compaq U.S.

compared these prices to its standard cost, which was on a

turnkey basis, using a process referred to as the turnkey

equivalent.   The turnkey equivalent is the sum of the turnkey

transactions and the adjusted consignment transactions.    Adjusted

consignment transactions are calculated by taking consignment

transactions with unrelated subcontractors and adding Compaq U.S.

standard material costs plus a material markup of 17.7 percent, a

markup that was derived from Compaq U.S. turnkey purchases of

$96.6 million from IEC Electronics Corporation (IEC), an

unrelated subcontractor of Compaq U.S.
                                                     - 22 -


                 The material markup used by Compaq U.S. was a function of

         the risk taken by the unrelated subcontractor.                        In the PCA

         industry during 1990 through 1993, material markups ranged from

         10 percent to 32 percent with an average at approximately 18 to

         20 percent.         To complete the comparison, the turnkey equivalent

         was then divided by the quantity of PCA's to arrive at a weighted

         average for unrelated subcontractor prices.

                 Between 1990 and 1993, Compaq U.S. purchased over

         3.6 million PCA's from 14 unrelated subcontractors at an

         aggregate price of $197.5 million on both a turnkey and

         consignment basis.            These purchases translated into an aggregate

         turnkey equivalent price of $597 million.

                 The following chart sets forth all Compaq U.S. purchases

         from unrelated subcontractors during 1990 to 1993:

                                  Power                       Memory        Video         Backplane/
                                 Supplies     Processors      Boards        Boards          Other        Total

Avex
Units                                    0          4,874         53,156              0        9,310       67,340
Purchases                               $0       $922,015     $1,262,726             $0     $600,392   $2,785,133
Turnkey equivalent purchases            $0     $1,725,009     $4,997,506             $0      $84,546   $6,807,061
% of Compaq U.S. standard cost                                                                              92.3%

Bull HN
Units                                    0         24,842               0             0            0        24,842
Purchases                               $0     $1,040,555              $0            $0           $0    $1,040,555
Turnkey equivalent purchases            $0    $13,462,015              $0            $0           $0   $13,462,015
% of Compaq U.S. standard cost                                                                               99.9%

Celestica
Units                                    0              0         13,044              0            0       13,044
Purchases                               $0             $0     $1,188,804             $0           $0   $1,188,804
Turnkey equivalent purchases            $0             $0     $2,677,985             $0           $0   $2,677,985
% of Compaq U.S. standard cost                                                                             127.8%

Citizen
Units                               150,796        17,935               0             0        8,770       177,501
Purchases                        $5,459,073    $3,472,731              $0            $0   $1,309,651   $10,241,455
Turnkey equivalent purchases     $5,430,032    $3,458,607              $0            $0           $0    $8,888,639
% of Compaq U.S. standard cost                                                                               92.8%
                                                      - 23 -


                                   Power                       Memory          Video         Backplane/
                                  Supplies     Processors      Boards          Boards          Other          Total

Philips
Units                                     0        239,040         2,927          3,676          48,572        294,215
Purchases                                $0     $8,201,016       $93,401        $98,540      $1,169,734     $9,562,691
Turnkey equivalent purchases             $0    $32,418,471      $572,876       $435,850      $3,248,842    $36,676,039
% of Compaq U.S. standard cost                                                                                  100.7%


GSS/Array
Units                                     0            935               0               0        7,535          8,470
Purchases                                $0        $74,301              $0              $0     $130,535       $204,836
Turnkey equivalent purchases             $0       $890,951              $0              $0     $142,016     $1,032,967
% of Compaq U.S. standard cost                                                                                  103.1%

IEC
Units                                218,017        30,501        856,975        354,865       1,114,749      2,575,107
Purchases                         $8,199,787    $3,002,002    $71,898,596    $12,483,282     $43,263,839   $138,847,506
Turnkey equivalent purchases     $13,210,344   $22,670,598   $189,562,990    $58,536,941     $94,979,747   $378,960,620
% of Compaq U.S. standard cost                                                                                   100.0%

Jabil
Units                                     0              0               0               0        5,170          5,170
Purchases                                $0             $0              $0              $0     $139,745       $139,745
Turnkey equivalent purchases             $0             $0              $0              $0     $649,008       $649,008
% of Compaq U.S. standard cost                                                                                   98.6%

Lung Hwa
Units                                     0         71,800               0               0            0         71,800
Purchases                                $0     $7,715,073              $0              $0           $0     $7,715,073
Turnkey equivalent purchases             $0    $13,382,018              $0              $0           $0    $13,382,018
% of Compaq U.S. standard cost                                                                                  103.2%

SCI
Units                                     0        138,611        35,715          8,772          20,208        203,306
Purchases                                $0     $6,609,212   $12,284,380       $120,016        $419,143    $19,432,751
Turnkey equivalent purchases             $0    $81,769,623    $7,572,742       $601,398      $2,640,192    $92,583,955
% of Compaq U.S. standard cost                                                                                  100.4%

Solectron
Units                                     0         18,612               0        5,747               0         24,359
Purchases                                $0       $900,327              $0     $176,032              $0     $1,076,359
Turnkey equivalent purchases             $0     $4,926,367              $0     $750,686              $0     $5,677,053
% of Compaq U.S. standard cost                                                                                   92.6%

Texas Instruments
Units                                     0          3,880               0               0            0          3,880
Purchases                                $0       $692,192              $0              $0           $0       $692,192
Turnkey equivalent purchases             $0     $2,214,649              $0              $0           $0     $2,214,649
% of Compaq U.S. standard cost                                                                                  105.9%

Victron
Units                                     0         38,938         1,150                 0       80,730        120,818
Purchases                                $0     $1,227,790        $8,165                $0   $1,558,070     $2,794,025
Turnkey equivalent purchases             $0    $11,293,117       $43,296                $0   $7,093,363    $18,429,776
% of Compaq U.S. standard cost                                                                                  96.70%

Xetel
Units                                     0         18,025               0        9,454               0         27,479
Purchases                                $0     $1,417,640              $0     $396,280              $0     $1,813,920
Turnkey equivalent purchases             $0    $15,063,197              $0     $606,661              $0    $15,669,858
% of Compaq U.S. standard cost                                                                                  110.3%
                                                      - 24 -


                                   Power                        Memory         Video       Backplane/
                                  Supplies     Processors       Boards         Boards        Other           Total


Vendor Totals
Units                                368,813        607,993        962,967       382,514     1,295,044       3,617,331
Purchases                        $13,658,860    $35,274,854    $86,736,072   $13,274,150   $48,591,109    $197,535,045
Turnkey equivalent purchases     $18,640,376   $203,274,622   $205,427,395   $60,931,536   $108,837,714   $597,111,643
% of Compaq U.S. standard cost                                                                                  100.2%
Average weighted by Compaq
  Asia production                                                                                               93.1%




         (Generally, the turnkey equivalent is greater than the actual

         purchases because the turnkey equivalent includes the aggregate

         purchase price in all transactions plus material cost and

         material markup components to adjust consignment transactions to

         the turnkey basis.             There are instances in the chart when the

         turnkey equivalent is less than the actual purchases from an

         unrelated subcontractor (i.e., Avex, Citizen, and SCI).                                This

         result is seemingly inconsistent with the foregoing definition of

         turnkey equivalent.

                 The deviation in the chart from the norm is attributable to

         petitioner's inability to locate standard cost data from Compaq

         U.S. to correspond with the PCA's purchased in certain

         transactions with the identified unrelated subcontractors.

         Accordingly, petitioner excluded the transactions from the

         analysis because petitioner was unable to compare the purchases

         from the unrelated subcontractor with the appropriate Compaq U.S.

         standard cost.

                 This chart compares the Compaq U.S. turnkey equivalent

         payments to unrelated subcontractors to the Compaq U.S. standard
                                - 25 -


costs for the PCA's.    The analysis indicates that Compaq U.S.

paid an average price to the unrelated subcontractors of

100.2 percent of Compaq U.S. standard cost.    If the average is

weighted to reflect Compaq Asia production of power supplies,

processors, memory boards, video boards and backplane/other

boards in 1991 and 1992, the analysis results in an average price

of 93.1 percent of Compaq U.S. standard cost.)

                       ULTIMATE FINDINGS OF FACT

     Compaq U.S. bought 3.6 million PCA's worth $597 million on a

turnkey equivalent basis from unrelated subcontractors.    The

PCA's were nearly identical to PCA's sold by Compaq Asia to

Compaq U.S.   After adjustment for differences in physical

property and circumstances of the sales, the prices that Compaq

U.S. paid to the unrelated subcontractors for PCA's were

comparable to the prices that Compaq U.S. paid to Compaq Asia for

PCA's.

                                OPINION

     The issue that we are considering here is whether the

transfer prices for PCA's that were charged between Compaq U.S.

and Compaq Asia meet the arm's-length standard of section 482.

Petitioner asserts that respondent's notice determinations are

unacceptable and that comparable transactions between unrelated

parties prove that the transfer prices satisfy the arm's-length
                               - 26 -


standard.    Petitioner argues that, under the CUP method dictated

by section 482 regulations, petitioner's proof must prevail.

     Respondent asserts that petitioner has not presented

comparable uncontrolled prices to prove that its transfer pricing

system should be upheld, and thus the amounts determined under

the notice of deficiency should be sustained or, alternatively,

that we should adopt the recommendations of respondent's experts.

Respondent's primary argument is that petitioner's turnkey

equivalent analysis is not based on actual transactions and,

therefore, does not satisfy the applicable regulations.

     Both parties presented experts to support their respective

positions.   We do not list or discuss here the qualifications of

the experts.   Our decision is not based on comparing

qualifications, and listing them would unduly lengthen this

opinion.    Similarly, we do not use titles in this opinion because

we do not wish to imply any greater deference to the academic

experts than to the industry experts.   Rather, we focus on the

degree to which the experts' opinions are supported by the

evidence.    We reject conclusory opinions that are unexplained or

are contrary to the factual evidence, and we do not discuss at

length any opinion that, although undisputed or logically

persuasive, does not affect our factual conclusions on this

issue.
                                - 27 -


     Section 482 gives respondent broad authority to allocate

gross income, deductions, credits, or allowances between two

related corporations if the allocations are necessary either to

prevent evasion of taxes or to reflect clearly the income of the

corporations.    See Seagate Tech., Inc. and Consol. Subs. v.

Commissioner, 102 T.C. 149, 163 (1994).     The applicable standard

is arm's-length dealing between taxpayers unrelated by ownership

or control.     See sec. 1.482-1A(b)(1), Income Tax Regs.   As stated

in Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353

(1991):

     The purpose of section 482 is to prevent the artificial
     shifting of the net incomes of controlled taxpayers by
     placing controlled taxpayers on a parity with
     uncontrolled, unrelated taxpayers. * * *

          * * * the regulations attempt to identify the
     "true taxable income" of each entity based on the
     taxable income which would have resulted had the
     entities been uncontrolled parties dealing at arm's
     length. * * *

When respondent has determined deficiencies based on section 482,

the taxpayer bears the burden of showing that the allocations are

arbitrary, capricious, or unreasonable.     See id.; Eli Lilly & Co.

v. Commissioner, 84 T.C. 996, 1131 (1985), affd. on this issue,

revd. in part, and remanded 856 F.2d 855, 860 (7th Cir. 1988).

     Respondent's section 482 determination must be sustained

absent a showing of abuse of discretion.     See Bausch & Lomb, Inc.

v. Commissioner, 92 T.C. 525, 582 (1989), affd. 933 F.2d 1084 (2d
                              - 28 -


Cir. 1991); G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 358

(1987); Paccar, Inc. v. Commissioner, 85 T.C. 754, 787 (1985),

affd. 849 F.2d 393 (9th Cir. 1988).    "Whether respondent has

exceeded his discretion is a question of fact.    * * *    In

reviewing the reasonableness of respondent's determination, the

Court focuses on the reasonableness of the result, not on the

details of the methodology used."     Sundstrand Corp. & Subs. v.

Commissioner, supra at 353-354; see also American Terrazzo Strip

Co. v. Commissioner, 56 T.C. 961, 971 (1971).    In most instances

where respondent abandons his notice position at trial, courts

conclude that allocations in the notice under section 482 are

arbitrary and capricious.   See, e.g., Sundstrand Corp. & Subs. v.

Commissioner, supra at 354-358; Perkin-Elmer Corp. & Subs. v.

Commissioner, T.C. Memo. 1993-414.

     Petitioner contends that respondent did not present evidence

to support the deficiencies in the notice.    In determining the

notice amounts, respondent redetermined the Compaq Asia prices

using section 1.482-2A(e)(1)(iii), Income Tax Regs.    Accordingly,

respondent increased Compaq Asia manufacturing costs by an

operating profit of 7.5 percent, resulting in a $232,402,000

income allocation with respect to Compaq Asia PCA's.      This

adjustment was based on reports of respondent's staff economist,

Balash.   At trial, Balash did not testify as an expert, and the

opinion portion of his report was not admitted as expert
                               - 29 -


evidence.   Instead, respondent relied heavily on the economic

analysis of Clark J. Chandler (Chandler) to support respondent's

section 482 allocation.   Respondent neither presented an

alternative CUP analysis nor proposed specific adjustments to

petitioner's analysis.

     Chandler used two cost-plus alternatives.   One, using IEC as

a cost-plus comparable, resulted in a weighted average markup on

total Compaq Asia standard costs of 15.2 percent.    After he

factored in accounting differences between Compaq Asia and IEC,

the result was a weighted average markup on Compaq Asia standard

costs of 6.5 percent.    Based on an analysis of operating margins

and operating profits as a percent of average operating assets,

as well as on an analysis of operating assets divided by total

assets, Chandler concluded that respondent's determination was

reasonable.   He also used underlying data from IEC to determine

weighted average CUP/cost-plus markups over Compaq Asia total

standard costs of 12.2 percent for 1991 and 14.2 percent for

1992.

     Chandler, however, used unrealistic material, labor, and

overhead markups in applying his formulas.    If markups in the

range of industry markups are used, the results of Chandler's

analysis bear no recognizable relation to respondent's notice

amounts.    As set forth below, petitioner's CUP analysis

establishes an arm's-length price for PCA purchases by Compaq
                              - 30 -


U.S. from Compaq Asia that is approximately $232 million greater

than respondent's determination in the notice.   Due to the

significant difference in these arm's-length prices and

respondent's determination in the notice of deficiency, we

conclude that respondent's allocations lead to an unreasonable

result and are thus arbitrary, capricious, and unreasonable.

     Respondent argues that the shortcomings of the notice should

be excused because respondent assertedly considered all of the

evidence available to him at the time that he issued the notice.

Respondent argues an analogy to ASAT, Inc. v. Commissioner, 108

T.C. 147, 166-167 (1997).   Specifically, respondent contends that

petitioner used the cost-plus method in arriving at the return

position but at trial used the CUP method to establish the arm's-

length prices of Compaq U.S. purchases from Compaq Asia.

Accordingly, respondent argues that the deficiency determination

should not be held arbitrary and capricious because, when the

notice position was formulated, it was reasonable.   Unlike the

situation in ASAT, Inc., which applied the sanction aspects of

section 6038A, respondent here was not denied any information

necessary to a reasonable determination.   Petitioner's change of

position is not the equivalent of unfair withholding of evidence.

Petitioner's conduct does not, in this case, enhance the

credibility of the statutory notice.
                                - 31 -


Arm's-Length Prices

     In addition to proving that the deficiencies set forth in

the notice are arbitrary, capricious, or unreasonable, petitioner

must also prove that the prices charged by Compaq Asia were

consistent with arm's-length pricing.     See Seagate Tech., Inc. &

Consol. Subs. v. Commissioner, 102 T.C. at 163; Eli Lilly & Co.

v. Commissioner, 84 T.C. at 1131.     The regulations set forth

three pricing methods to determine whether there is an

appropriate arm's-length price.     First, if comparable

uncontrolled sales exist, the regulations mandate that the CUP

method be used.   If there are no comparable uncontrolled sales,

the resale price method must be utilized if the standards for its

application are met.     If the standards for the resale price

method are not satisfied, either that method or the cost-plus

method may be used, depending upon which method is more feasible

and is more likely to result in an accurate estimate of an arm's-

length price.   Where none of the three methods can be reasonably

applied, some other appropriate method may be used.     See sec.

1.482-2A(e)(1), Income Tax Regs.

     Under the CUP method, the arm's-length price of a controlled

sale is equal to the price paid in comparable uncontrolled sales

including necessary adjustments.     "Uncontrolled sales" are sales

in which the seller and the buyer are not members of the same

controlled group.     These include sales between a member of the
                              - 32 -


controlled group and an unrelated party, as well as unrelated

sales in which none of the parties are members of the controlled

group.   Uncontrolled sales are considered "comparable" to

controlled sales if the physical property and circumstances

involved in the uncontrolled sales are identical to the physical

property and circumstances involved in the controlled sales or if

such properties and circumstances are so nearly identical that

differences either have no effect on price or such differences

can be reflected by a reasonable number of adjustments to the

price of the uncontrolled sales.   Adjustments can be made only

where such differences have a definite and reasonably

ascertainable effect on price.   Some of the differences listed in

the regulations as possibly affecting price are differences in

quality, terms of sale, intangible property associated with the

sale, level of the market, and geographic market in which the

sales takes place.   Whether differences render sales

noncomparable depends upon the particular circumstances and

property involved.   See sec. 1.482-2A(e)(2), Income Tax Regs.

     Petitioner has presented substantial evidence of

uncontrolled transactions with unrelated subcontractors.

Petitioner's CUP analysis is predicated on Compaq U.S. purchases

of 3.6 million PCA's from unrelated subcontractors between 1990

and 1993.   The aggregate purchase price of these PCA's totaled

$597 million on a turnkey equivalent basis and was 93.1 percent
                                - 33 -


of the Compaq U.S. standard cost.    In addition, the purchases

occurred in the regular course of business and were substantial

in both frequency and amount.    See Seagate Tech., Inc. & Consol.

Subs. v. Commissioner, supra at 188 (rejecting CUP comprised of

single transaction).   Although these transactions were not

identical to the controlled transactions involving Compaq Asia,

we conclude that they are sufficiently similar to provide a

reliable measure of an arm's-length result.    Thus, the purchases

from unrelated subcontractors identified by petitioner qualify as

comparable uncontrolled sales for purposes of application of the

CUP method.

     Compaq U.S. purchases of PCA's from unrelated

subcontractors, however, differ in some respects from the PCA

purchases from Compaq Asia.     Accordingly, within the context of

section 1.482-2A(e)(2)(ii), Income Tax Regs., and the particular

facts in this case, the specific differences between the Compaq

U.S. purchase of PCA's from Compaq Asia and unrelated

subcontractors must be examined to determine "Whether and to what

extent differences in the various properties and circumstances

affect price."

     As expressly authorized by section 1.482-2A(e)(1)(iv),

Income Tax Regs., Compaq U.S. segregated the PCA purchases from

Compaq Asia and unrelated subcontractors into different

categories of PCA's.   Within each category, the PCA's had only
                               - 34 -


minor physical differences.    The difference in price relating to

the minor differences in physical properties can be quantified

with definite and reasonably ascertainable adjustments.    See sec.

1.482-2A(e)(2)(ii), Example (3), Income Tax Regs. ("Since minor

physical differences in the product generally have a definite and

reasonably ascertainable effect on prices, such differences do

not normally render the uncontrolled sales noncomparable to the

controlled sales.").

     The record demonstrates that the only differences in PCA's

within each product category were the particular components used

on each individual PCA and the time required to process PCA's on

the manufacturing line.   We are persuaded that these differences

can be corrected with adjustments to Compaq U.S. standard costs.

The Compaq U.S. standard cost of labor and overhead is equal to

the time required to process a given PCA multiplied by the Compaq

U.S. hourly labor and overhead rate.    The Compaq U.S. standard

material cost for a given PCA is the sum of the unburdened

purchase order prices for each and every component used on the

PCA as set forth in the bill of materials.    Thus, according to

petitioner, the Compaq U.S. standard costs account for

differences in the time required to process a PCA and in the cost

of the materials on the PCA.

     Based on the uncontrolled purchases of 3.6 million PCA's,

the turnkey equivalent price of PCA's purchased from unrelated
                              - 35 -


subcontractors was 93.1 percent of the Compaq U.S. standard costs

weighted to the Compaq Asia production amount.    Compaq Asia

turnkey prices were 93.9 percent of the Compaq U.S. standard

cost.   Thus, the relationship between Compaq Asia prices and

unrelated subcontractors prices is definite, and a reasonably

accurate adjustment can be made using these ratios.

     Adjusting for minor physical differences and differences in

production time in this manner is consistent with Compaq U.S.

actual arm's-length dealings and real world experience:

unrelated subcontractor prices are directly related to Compaq

U.S. standard costs to produce the PCA's in-house.     Accordingly,

a decrease of $6.4 million in the Compaq Asia aggregate price may

be warranted for physical differences and differences in

production time.

     Quality is also a factor that may affect price.    In this

case, however, no adjustment is necessary because the PCA's that

were purchased from Compaq Asia were of equal or greater quality

than the unrelated subcontractor PCA's.

     Compaq U.S. occasionally reworked defective PCA's that were

purchased from Compaq Asia and unrelated subcontractors.    In so

doing, Compaq U.S. reworked a significantly higher percentage of

unrelated subcontractors' PCA's than of Compaq Asia PCA's.

During 1991 and 1992, Compaq U.S. incurred costs of $1.3 million

to rework defective Compaq Asia PCA's.    Compaq U.S. did not
                               - 36 -


charge Compaq Asia or unrelated subcontractors for this rework

activity.    Petitioner, however, adjusted the uncontrolled price

by the full amount of Compaq U.S. rework costs on Compaq Asia

PCA's, decreasing the Compaq Asia aggregate price by the

$1.3 million of rework of defective PCA's.

       Differences in payment terms also affect price, but an

adjustment can be made to make controlled and uncontrolled sales

comparable.    In this case, Compaq U.S. paid unrelated

subcontractors in 30.3 days and paid Compaq Asia in 90.9 days.

Using the contemporaneous monthly prime rate, the payment term

adjustment sought by petitioner would increase the Compaq Asia

aggregate price by $8.9 million.

       Only one adjustment is necessary for the intangible property

associated with the controlled and uncontrolled transactions.

Compaq U.S. purchased power supplies from unrelated

subcontractors and Compaq Asia.    Unlike unrelated subcontractors

such as IEC and Citizen, which merely built power supplies to

Compaq U.S. specifications, Compaq Asia had joint design

responsibilities for power supplies with Compaq U.S.      Thus, all

things being equal, Compaq Asia should have been paid more than

the unrelated subcontractors for the services provided to Compaq

U.S.    The uncontroverted evidence establishes that, in the power

supply sector of the PCA industry, power supply design services

add approximately 5 percent over and above the price to have
                              - 37 -


power supplies manufactured to specifications.    Thus, petitioner

contends that an upward adjustment of 5 percent is appropriate to

make uncontrolled subcontractor power supply prices comparable to

that of Compaq Asia power supply prices.   This adjustment would

increase the Compaq Asia aggregate power supply price by an

additional 5 percent.

     The regulations also state that differences in the level of

the market at which purchases are made may impact price.     See

sec. 1.482-2A(e)(2)(ii), Income Tax Regs.; see also Woodward

Governor Co. v. Commissioner, 55 T.C. 56, 66-67 (1970).      In this

case, there is no difference in the level of the market.     Compaq

Asia and unrelated subcontractors functioned as subcontractors to

Compaq U.S.   Thus, no adjustment is necessary.

     Definite and reasonably ascertainable adjustments are also

necessary if the geographic market in which the sales take place

has an effect on price.   See sec. 1.482-2A(e)(2)(ii), Income Tax

Regs.   Compaq U.S. subcontractors were primarily located in the

United States and sold "FOB plant".    Compaq Asia was located in

Singapore and sold "FOB plant".   While Compaq Asia and the

unrelated subcontractors sold their PCA's from different

locations, they all sold their products into the same market--

the United States.   The PCA industry is global in nature, and

Compaq Asia competitors for Compaq U.S. business were located

primarily in the United States.   Contrary to respondent's
                              - 38 -


contentions, Compaq Asia was not competing with unrelated

subcontractors in Singapore because those entities did not have

the technology, equipment, engineering, or training required to

make Compaq U.S. PCA's.   Compaq U.S. exercised its business

judgment during 1991 and 1992, when it needed additional PCA's,

in purchasing those PCA's from unrelated subcontractors in the

United States.   Respondent may not substitute his business

judgment for petitioner's under the guise of a section 482

allocation.   See Bausch & Lomb, Inc. v. Commissioner, 92 T.C. at

593; Seminole Flavor Co. v. Commissioner, 4 T.C. 1215, 1235

(1945).

     Compaq U.S. did, however, incur higher freight and duty

costs when shipping PCA's from Compaq Asia rather than from the

mostly U.S.-based unrelated subcontractors.    Thus, price

adjustments to reflect these differences are appropriate but do

not render uncontrolled sales noncomparable.    See sec. 1.482-

2A(e)(2)(ii), Example (1), Income Tax Regs.    The incremental

freight costs that were required to ship PCA's from Compaq Asia

during 1991 and 1992 were $2.6 million, decreasing the Compaq

Asia aggregate price by that amount.   The parties also stipulated

to the net duty costs that were incurred on the Compaq U.S.

purchase of Compaq Asia PCA's.   Compaq U.S. would not have

incurred this net duty cost if it had purchased the PCA's from

the primarily U.S.-based unrelated subcontractors.    During 1991
                              - 39 -


and 1992, the appropriate adjustment for duty costs was to reduce

Compaq Asia prices by $1.2 million to make them comparable with

unrelated subcontractor prices.

     Compaq U.S. paid unrelated subcontractors for setup and

cancellation charges but did not pay Compaq Asia for similar

costs.   Thus, at arm's length, an adjustment must be made for the

setup and cancellation charges paid to the unrelated

subcontractors.   According to petitioner, for 1991 and 1992, the

appropriate adjustment for the setup and cancellation charges was

a $2.9 million increase in Compaq Asia prices.

     Regarding material inventories, petitioner argues that

Compaq Asia had more at risk than did unrelated subcontractors,

because Compaq Asia purchased materials and components based on a

nonbinding forecast.   Accordingly, if either demand or design for

a PCA changed, Compaq Asia bore the risk that its materials and

components inventory would not be used or would become obsolete.

The unrelated subcontractors, on the other hand, waited until

they received a firm purchase order before they committed to

buying materials and components.   Furthermore, Compaq U.S.

contractually committed to be responsible for the materials and

components inventories in the event that demand or design

changed.   Thus, Compaq U.S. and not the unrelated subcontractors

bore the risk that design or demand would change.   At arm's

length, an adjustment is required to reflect the risks and costs
                               - 40 -


borne by Compaq Asia that were not borne by the unrelated

subcontractors.   The parties stipulated that, during 1991 and

1992, Compaq Asia incurred $4.6 million in expenses related to

cancellation of raw material contracts and component

obsolescence.   Of that amount, $4.2 million is attributable to

PCA cancellation and obsolescence costs with the remaining

$400,000 attributable to CPU cancellation and obsolescence costs.

     The price adjustments asserted and quantified by petitioner

are summarized in the following table:

                                          Compaq Asia Price
                                         Increase/(Decrease)
PCA price adjustment                          ($6.4 million)
Transactional adjustments
Add:
     Payment terms                             $8.9 million
     Advance purchase costs                    $4.2 million
     Setup & cancellation charges              $2.9 million
Less:
     Freight                                  ($2.6   million)
     Duties                                   ($1.2   million)
     Defective PCA costs                      ($1.3   million)
Overall PCA price adjustment                   $4.5   million


These adjustments would indicate that Compaq U.S. paid prices to

Compaq Asia that were less than the comparable prices paid by

Compaq U.S. to the unrelated subcontractors for nearly identical

PCA's, adjusted for physical and transactional differences.
                             - 41 -


     Petitioner somewhat inconsistently asks at some points that

the Compaq Asia price be adjusted upward and at others that no

section 482 adjustment be made.    To the extent that petitioner

implies that it is entitled to an affirmative adjustment reducing

its U.S. tax liability, the evidence shows only consistency with

arm's-length pricing, not inadequate pricing.    In view of the

necessity of approximations and adjustments, we are not persuaded

that the prices contemporaneously charged by Compaq Asia to

Compaq U.S. and used in petitioner's tax reporting should be

retroactively adjusted to the advantage of petitioner.

     Respondent, despite the Court's urging at the conclusion of

trial, provides no alternative adjustment calculations.

Respondent attacks petitioner's CUP analysis on several grounds,

arguing that flaws in petitioner's reasoning undermine the

credibility of petitioner's CUP.    First, respondent argues that a

majority of transactions constituting the CUP are consignment

purchases converted to turnkey prices, the turnkey equivalent,

and do not represent actual sales.    Respondent argues that these

transactions cannot be used as comparable prices to the turnkey

transactions with Compaq Asia, because consignment purchases

cannot accurately be converted to comparable prices.

     Respondent's argument is unsupported by the record and was

contradicted by respondent's expert, Chandler.    Chandler's

testimony on cross-examination included the following:
                              - 42 -


          Q    * * * your objections to the adjustment from
     consignment to turnkey then, in terms of the real world
     markup, really just come down to what the material
     markup is, right?
          A    Oh yes. That actually--yes. I have no
     qualms, the clear issue is how large the markup should
     be.
          Q    So you and I can agree that you can adjust
     from consignment to turnkey transactions, and you can
     do so with certainty.
          A    You can adjust from consignment to turnkey
     transactions, the--when you say whether you can do it
     with certainty is somewhat problematic since I clearly
     believe that sort of the 5 percent net should be done
     here and you believe that the 17.7 percent of gross
     should be used and that is a lot of money.
          Q    And the certainty point is that there is a
     range of different markups in the marketplace, isn't
     there?
          A    Yes.

Moreover, we do not believe that excluding the turnkey equivalent

transactions from the analysis would change the result here.

Respondent's failure to provide an alternative CUP analysis

supports our impression that the undisputed actual transactions

establish arm's-length consistency for petitioner's pricing.

     Respondent also challenges the use of 17.7 percent as a

material markup, arguing that markups on other transactions were

less than 17.7 percent.   Respondent's contention is that the

excessive markup allows Compaq Asia to earn too much money.

Instead, respondent advocates the use of a 5-percent material

markup, despite not being able to point to one single arm's-

length transaction that took place at such a minimal markup.
                               - 43 -


     At trial, petitioner presented evidence showing that Compaq

U.S. paid a 17.7-percent material markup on $96 million of

turnkey purchases from IEC and that the 17.7-percent IEC markup

was typical in the PCA industry.    Respondent's expert, Chandler,

also conceded that this markup was consistent with and fell

within the middle of the range of material markups actually

observed in the marketplace.   Thus, the Compaq Asia use of the

17.7-percent markup was appropriate and in accord with the

evidence in this case.

     Respondent also argues that the PCA's in the controlled and

uncontrolled transactions were not identical or nearly identical

as required by section 1.482-2A(e)(2)(ii), Income Tax Regs.      The

overwhelming evidence established that the PCA's within each

category were substantially similar or nearly identical and

differed in only two respects:    (i) The cost of the specific

components and materials used on each PCA and (ii) the amount of

time required to process each PCA.      As set forth above, in

accordance with the applicable regulations, adjustments can be

and were made to make the transactions comparable.      Accordingly,

transactions with unrelated subcontractors warranted application

of the CUP method.

     Respondent argues that volume discounts should apply to

Compaq Asia sales in this case.    The regulations do not enumerate

volume as a factor that may impact price; rather, the regulations
                              - 44 -


merely provide that comparable uncontrolled sales "do not include

sales at unrealistic prices, as for example where a member makes

uncontrolled sales in small quantities at a price designed to

justify a nonarm's-length price on a large volume of controlled

sales."   Sec. 1.482-2A(e)(2)(ii), Income Tax Regs.   See generally

Bausch & Lomb, Inc. v. Commissioner, 92 T.C. at 592.

     Petitioner presented substantial evidence showing that the

prices that Compaq U.S. actually paid to unrelated suppliers,

although quoted by volume, were not ultimately established by

volume.   Testimony on this point came from the unrelated

subcontractors as well as from Compaq U.S. purchasing personnel.

The industry experts, Ray Prasad, Charles-Henri Mangin, and Tim

Faucett, similarly opined that the higher volume did not lead to

lower prices in this case.   The testimony was that volume had no

effect on price because unrelated subcontractors gave Compaq U.S.

their best prices in light of the Compaq U.S. market position and

overall level of potential business.    Compaq U.S. was big enough

and bought enough PCA's that it was able to demand and receive

the best prices regardless of volume.

     Respondent also challenges petitioner's use of unrelated

subcontractor transactions from 1990 and 1993 in establishing an

arm's-length price under the CUP method.   Respondent argues that

using transactions with unrelated subcontractors from 1990 and

1993 was inappropriate and tainted the validity of the CUP.
                               - 45 -


     Using comparable transactions from years prior to the

taxable years in issue is common in section 482 cases.    See

Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. at 272-276,

305-309, 375-377, 392-395 (using comparable transactions from up

to 20 prior years); Bausch & Lomb, Inc. v. Commissioner, supra at

587, 593 (using comparable sales from prior years); Ciba-Geigy

Corp. v. Commissioner, 85 T.C. 172, 215-216, 224 (1985) (using

comparable transactions from up to 12 years prior to the years in

issue).

     The transactions from 1990 and 1993 identified and used by

petitioner did not significantly impact the conclusions of the

CUP method.   During 1990 to 1993, the prices that were paid to

the unrelated subcontractors averaged 93.1 percent of the Compaq

U.S. standard cost.    During 1990 to 1992, the arm's-length prices

that were paid to the unrelated subcontractors averaged

93.9 percent of the Compaq U.S. standard cost, and, during 1991

to 1992, the arm's-length price that was paid to the PCA

subcontractors averaged 92.2 percent of the Compaq U.S. standard

cost.   Thus, to the extent that uncontrolled PCA prices changed

over time, the Compaq U.S. standard costs moved with the

uncontrolled prices.

     Ultimately, respondent argues that, because the CUP method

cannot be applied, a profits-based fourth method is the

appropriate method of determining arm's-length prices in this
                                - 46 -


case.     The Court was faced with the same "prices v. profit"

argument in Bausch & Lomb, Inc.     In that case, B&L Ireland, like

Compaq Asia, had a lower cost structure than its competitors.

Respondent argued in Bausch & Lomb, Inc., as he does here, that

B&L Ireland should have earned the same net profit margins as its

competitors.     This Court held:

        The fact that B&L Ireland could, through its possession
        of superior production technology, undercut the market
        and sell at a lower price is irrelevant. Petitioners
        have shown that the $7.50 they paid for lenses was a
        "market price" and have thus "earned the right to be
        free from section 482 reallocations." * * * [Bausch &
        Lomb, Inc. v. Commissioner, supra at 592-593.]

The same is true in the present case.     The CUP method establishes

arm's-length prices for PCA's that were sold by Compaq Asia, and

a large profit margin does not prevent use of the CUP method.

        In summary, respondent's position ignores the prices that

were paid by Compaq U.S. to unrelated subcontractors.     Instead,

respondent contends that Compaq Asia should earn the same net

profit margins, while not charging the same prices, as the

comparable companies.     Because Compaq Asia costs were less than

the costs of comparable companies, respondent asserts that the

prices that were paid to Compaq Asia should be $232 million less

than the prices that were paid to the unrelated subcontractors

for comparable PCA's.     Respondent, however, is unable to identify

a single actual market participant that sold PCA's at only two-

thirds of the prevailing market price.
                             - 47 -


Conclusion

     Petitioner has satisfied its burden of proving that the

prices in the intercompany transactions were consistent with

arm's-length prices.

     Our holdings in this opinion will be incorporated into the

decision to be entered in this case when all other issues are

resolved.
