                         T.C. Memo. 1996-57



                       UNITED STATES TAX COURT



          BAUSCH & LOMB INCORPORATED AND CONSOLIDATED
                  SUBSIDIARIES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 13983-91, 1215-92.    Filed February 15, 1996.



     Dennis I. Meyer, C. David Swenson, A. Duane Webber, Diane S.

Rohleder, J. Michael Cornett, and John W. Polk, for petitioners.

     Matthew J. Fritz, Jeffrey L. Bassin, Nancy Ortmeyer Kuhn,

and Judith Cavell Cohen, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHIECHI, Judge:    Respondent determined the following defi-

ciencies in petitioners' Federal income tax:

               Taxable Year Ended       Deficiency

                 Dec. 25, 1983         $9,340,688
                 Dec. 30, 1984         14,947,579
                                - 2 -


                 Dec. 29,   1985         5,417,150
                 Dec. 28,   1986         6,529,257
                 Dec. 27,   1987         5,339,670
     The following issues   remain for decision:1

     (1)   Does the income for each of the years at issue from the

sale of sunglasses assembled2 by Bausch & Lomb Ireland, Ltd. (B&L

Ireland) and by Bausch & Lomb Hong Kong, Ltd. (B&L Hong Kong)

constitute foreign base company sales income as defined in

section 954(d)(1) that is includible in petitioners' gross income

under section 951(a)(1)?    We hold that it does not.

     (2)   Did respondent abuse her discretion under section

954(b)(4) by failing to exclude certain income of B&L Hong Kong

from sources other than the sale of sunglasses it assembled3 from

petitioners' gross income for their taxable years




1
   Prior to the trial herein, the Court granted the parties'
joint motion to sever a capital loss carryback issue relating to,
inter alia, petitioners' taxable year ended Dec. 27, 1987. Since
that year is one of the years at issue in docket No. 1215-92, no
decision may be entered in that case at the present time.
2
   Unless otherwise indicated, our use herein of the words "as-
sembled", "produced", "manufactured", and similar words does not
reflect the Court's view as to whether the sunglasses assembled
by Bausch & Lomb Ireland, Ltd. and by Bausch & Lomb Hong Kong,
Ltd. were manufactured by each of those companies for purposes of
sec. 954(d)(1).

   All section references are to the Internal Revenue Code (Code)
in effect for the years at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
3
   Not all of B&L Hong Kong's income from sources other than the
sale of sunglasses it assembled is at issue herein. See discus-
sion infra.
                               - 3 -


endedDecember25, 1983, through December 28, 1986?4   We hold that

she did not.

                         FINDINGS OF FACT5


4
   In light of our holding on issue (1), we need not, and shall
not, address petitioners' contention that B&L Hong Kong's income
from the sale of sunglasses it assembled is excludible from
petitioners' gross income for each of those years under sec.
954(b)(4).
5
   At the conclusion of the trial herein, the Court ordered the
parties to file seriatim briefs and limited the parties' respec-
tive briefs to a total of 150 pages, including the proposed
findings of fact. Petitioners' opening and reply briefs totaled
exactly 150 pages. It appears that they were able to so limit
their briefs only by violating Rule 151(e)(3). That Rule
requires the opening briefs of the parties to contain:

    Proposed findings of fact * * * based on the evidence, in
    the form of numbered statements, each of which shall be
    complete and shall consist of a concise statement of essen-
    tial fact and not a recital of testimony nor a discussion
    or argument relating to the evidence or the law. * * *

Petitioners' opening brief did not contain any "Proposed findings
of fact * * * in the form of numbered statements" with respect to
any facts to which the parties stipulated in the revised first
stipulation of facts (first stipulation) and to which neither
party objected on evidentiary grounds. Respondent objected in
her brief to petitioners' failure to propose such stipulated
facts and their resultant violation of Rule 151(e)(3). However,
respondent did not request the Court to impose sanctions on
petitioners.

  During the pretrial and trial phases of these cases, petition-
ers' lead counsel made it known to the Court on a number of
occasions that he is no stranger to this Court, since he has
appeared before us as attorney of record in a number of different
cases. We therefore presume that he is, and in any event he and
all counsel who appear before us should be, thoroughly familiar
with this Court's Rules, including Rule 151(e)(3). Since respon-
dent did not seek any sanctions from the Court for petitioners'
failure to comply with Rule 151(e)(3), which we view as nothing
more than their attempt to circumvent the page limitation we
                                                   (continued...)
                              - 4 -




     Some of the facts have been stipulated and are so found.6

     Bausch & Lomb Incorporated (B&L Inc.) is a corporation

organized under the laws of the State of New York.   At the time

the petitions were filed, its principal corporate offices were

located in Rochester, New York (Rochester).   B&L Inc. and certain

of its subsidiaries filed consolidated Federal income tax returns

(Forms 1120) for the taxable years ended December 25, 1983,

December 30, 1984, December 29, 1985, December 28, 1986, and

December 27, 1987.

     For each of the years at issue,7 petitioners kept their

books and records and filed their Federal income tax returns on

the accrual method of accounting using a 52-53 week taxable year.

B&L Inc. was a U.S. shareholder of B&L Ireland and of B&L Hong

Kong within the meaning of section 951(b), B&L Ireland and B&L

Hong Kong were controlled foreign corporations (CFCs) of peti-


5
 (...continued)
placed on the briefs in these cases, we shall impose no sanctions
at this time. However, we caution petitioners and their counsel
that any further violations of our Rules and Orders will be met
with the imposition of appropriate sanctions, regardless whether
respondent makes a request for sanctions.
6
   Each party objected to certain stipulations in the first
stipulation, the second stipulation of facts, and the third
stipulation of facts. (Those stipulations will be referred to
collectively as the stipulations of facts.) We address those
objections below.
7
   Unless otherwise indicated, our Findings of Fact and Opinion
herein relate to the years at issue.
                               - 5 -


tioners within the meaning of section 957(a), and B&L Ireland and

B&L Hong Kong maintained their books and records on the accrual

method of accounting using a 52-53 week taxable year.

B&L Inc. and Subsidiaries8

     B&L traces its roots to an optical shop located in Rochester

that was founded in 1853 by John J. Bausch and Henry Lomb.    Prior

to World War I, B&L became the first producer in the United

States of optical quality glass, a vital material for military

instruments, that freed the United States from its dependence on

European sources of such glass.

     Prior to and during the years at issue, B&L manufactured and

sold a wide range of optical-related products, including contact

lenses, contact lens solutions, sunglasses,9 binoculars, tele-

scopes, and scientific instruments (e.g., microscopes).10    Prior

to the years at issue, B&L manufactured and sold prescription

eyeglasses.   Prescription eyeglasses are a separate and distinct

product from noncorrective sunglasses.   Prescription eyeglasses

contain individually finished, corrective lenses, are tailored



8
   Hereinafter, we shall refer to B&L Inc. and all of its sub-
sidiaries, not just those subsidiaries that were consolidated for
Federal income tax purposes, as B&L.
9
   As used herein, the term "sunglasses" means sunglasses with
noncorrective lenses.
10
   B&L was also involved in certain biomedical fields. However,
that segment of its business is not relevant to the issues
presented in these cases.
                               - 6 -


for a specific prescription and to fit an individual face, and

are assembled by retail optical shops.   In contrast, sunglasses

have noncorrective lenses, are tailored to fit a standard face,

and are assembled prior to reaching the retailers.   B&L discon-

tinued its prescription eyeglasses product line during 1981.    As

of 1987, B&L performed manufacturing or marketing operations in

25 countries and its products were distributed in over 70 coun-

tries.

     B&L began manufacturing and selling soft contact lenses

during 1971.   Prior to 1980, B&L's only manufacturing facility

that had the ability to produce soft contact lenses using the

spin cast process was located in Rochester (Rochester facility).

B&L determined that it was prudent to establish additional soft

contact lens manufacturing capacity overseas in order to minimize

regulatory delays, establish an alternative supply source to the

Rochester facility, and have a facility capable of more effi-

ciently serving the increasingly important European markets.

Because of incentives, including tax benefits, offered by the

Government of the Republic of Ireland (Ireland) to induce com-

panies to establish manufacturing facilities in Ireland, it was

determined that B&L could realize those objectives most cost

effectively in Ireland.   Accordingly, for valid business reasons,

on February 1, 1980, B&L Ireland was incorporated under the laws

of Ireland to manufacture contact lenses.   B&L Ireland's contact
                               - 7 -


lens manufacturing facility was located in an industrial estate

in Waterford, Ireland (Waterford industrial estate).

     During the 1970s and the 1980s, B&L was increasingly turning

its attention to international markets, including Southeast Asia

where B&L was experiencing rapid growth in the sale of its

products.   Prior to 1972, B&L distributed its sunglasses and

other products in certain Southeast Asian markets through in-

dependent distributors unrelated to B&L (independent distribu-

tors) that sold products other than B&L products, including in

the case of at least one such distributor sunglasses produced by

a competitor of B&L.   The independent distributors did not focus

on B&L products, and B&L maintained no direct contact with the

retail optical shops in Southeast Asia that sold its sunglasses

to consumers.   In addition, B&L did not maintain any inventory in

Southeast Asia and experienced long lead times on product orders

originating in that market due to a delay in shipping products

from the United States to that part of the world.   This was the

case even though during the early 1970s B&L was experiencing

rapid sales growth in Southeast Asia as that market began to

develop and its consumers could afford more luxury-type products.

     In 1971, B&L opened an office in Hong Kong, its largest

market in Southeast Asia.   Although that office, which it called

a representative office, acted as a liaison between B&L and its

independent distributors, it did not maintain any inventory or
                               - 8 -


employ its own sales force.   In order to improve customer service

and reduce the lead time on product orders, the director of the

representative office in Hong Kong suggested to the Ophthalmic

Division of B&L Inc.11 in Rochester that B&L operate a warehouse

to maintain an inventory in Hong Kong.   It was the understanding

of B&L that any office that maintained inventory in Hong Kong had

to be incorporated in Hong Kong.

     The Ophthalmic Division of B&L Inc. decided to incorporate

B&L Hong Kong in 1972 for the primary purposes of distributing

sunglasses and other B&L products in Hong Kong and related

markets in Southeast Asia and improving customer service and

expanding B&L's business in Southeast Asia.   In connection with

the decision to establish distribution operations in Hong Kong,

B&L considered Hong Kong's labor costs, its political stability,

its historic role as a trading center, any logistical difficulty

of managing the Asian distribution function from Rochester, and

the inadequacy of its marketing and sales in Southeast Asia, in

particular in Hong Kong, because of its reliance on independent

distributors.

     From 1972 through 1981, B&L Hong Kong functioned, inter

alia, as a marketing, sales, warehousing, and distribution

facility that purchased sunglasses, contact lenses, contact lens


11
   The Ophthalmic Division was one of two main divisions of B&L
Inc. at the time the decision to incorporate B&L Hong Kong was
made.
                               - 9 -


solutions, ophthalmic frames and lenses, scientific instruments,

and other B&L products from related suppliers and sold them

primarily to unrelated customers in Hong Kong, Taiwan, the

Philippines, Singapore, Malaysia, Thailand, and Indonesia.

During those years, B&L Hong Kong's largest selling products were

sunglasses that it purchased from B&L and that it did not as-

semble in Hong Kong, and its largest sales market for those

sunglasses was Hong Kong.   Throughout the period 1972 through

1981, B&L Hong Kong, and not B&L Inc., made the decisions affect-

ing B&L Hong Kong's operations that related to its (1) leasing

facilities, (2) personnel, (3) selection of the B&L product lines

it offered, (4) B&L product inventory levels, (5) processing and

billing of customer orders, and (6) account management.   During

those years, B&L Hong Kong expanded its sales of B&L products

from approximately $300,000 to $10 million.

     B&L's management was aware that the tax rates in Hong Kong

were lower than the tax rates in the United States during and

immediately prior to the years at issue, and B&L's management

made efforts during those years to reduce its overall tax burden.

B&L Sunglasses

     B&L began producing sunglasses in 1930 in response to an

inquiry from the U.S. Army Air Corps, whose pilots needed protec-

tion from the glare of the sun while flying above the clouds.

B&L began marketing sunglasses to the general public in 1936.
                                - 10 -


Since 1937, B&L has marketed its sunglasses principally under the

name "Ray-Ban".

      Ray-Ban sunglasses are premium quality sunglasses that are

priced two-to-ten times higher than regular sunglasses.   Ray-Ban

sunglasses contain optical-quality, glass lenses that are impact

resistant and designed to protect the wearer from harmful ultra-

violet rays without distorting his or her natural vision.

      B&L produced, inter alia, the following styles of sun-

glasses, all of which bore the logo Ray-Ban:   (1) Sunglasses with

metal temples and fronts and glass lenses that B&L and we refer

to as metals or metal sunglasses,12 (2) sunglasses with metal

temples and fronts covered in whole or in part with leather and

glass lenses that B&L and we refer to as leathers, (3) sunglasses

with plastic temples and fronts and glass lenses that B&L and we

refer to as plastics or plastic sunglasses,13 and (4) sunglasses

with nylon temples and fronts14 and glass lenses that B&L and we

refer to as Cats.   B&L also produced sunglasses with metal

temples and fronts and a one-piece plastic shield as a lens that

B&L and we refer to as Wings.

      B&L used stock keeping units (SKUs) to keep track of the


12
   Metals included styles of sunglasses known as large metals,
large metals II, Outdoormans, and Caravans.
13
     Plastics included a style of sunglasses known as Wayfarers.
14
   B&L purchased the nylon temples and nylon fronts from an
unrelated vendor.
                              - 11 -


finished sunglasses that it produced and sold.   Every different

type of finished sunglass product made by B&L was assigned a

different SKU and represented a separate inventory item.     Any

variation in the sunglasses caused them to be assigned a dif-

ferent SKU.   Thus, for example, if two pairs of large metals

contained different colored lenses, or two pairs of Wayfarers

were made with different colors of plastic, they were assigned

different SKUs even though they were identical in every other

respect.

     Prior to and during the years at issue, B&L's primary

facilities for producing sunglasses were located in Rochester.

B&L performed both parts fabrication and assembly in Rochester.

B&L treated parts fabrication and assembly as separate operations

and, regardless of location, considered its assembly facilities

as customers of its parts fabrication facilities.

     For all relevant periods until sometime in 1986, B&L pro-

duced the glass lenses for its Ray-Ban sunglasses in its glass

plant in Rochester (glass plant).   The glass plant used a large

glass tank capable of being subjected to extreme heat to turn

sand and oxides into a molten material that could be pressed into

shape for use as lenses in Ray-Ban sunglasses.   Because plastic

lenses had taken over the market for prescription eyeglasses by

1986, the glass plant was not commercially viable and was closed.

B&L licensed its glass lens-making technology to Schott Glass
                              - 12 -


Technology (Schott Glass), an unrelated third-party vendor that

specialized in making glass products.    B&L worked closely with

Schott Glass to ensure that it produced quality lenses for use in

Ray-Ban sunglasses.

     B&L fabricated the parts for its metals in its Frame Center

in Rochester (Frame Center) and its plant in Pforzheim, Germany,

that was operated by B&L GmbH, a subsidiary of B&L Inc.15    B&L

put metal wire through a multiple-step process in order to

produce the parts known as metal temples or fronts that were used

in assembling certain of its sunglasses.   Machines were used to

draw, form, bend, or cut the metal wire and to press holes into

the parts to create threaded holes.    An electroplated coating was

applied to the metal temples and fronts.   As part of the process

of fabricating metal sunglass parts, metal temples and fronts

were subjected to 20 to 40 specific inspection steps, some of

which involved random samples.

     In the process of fabricating plastic frames, sheets of

plastic were pressed by B&L to cut out plastic temples and

fronts.   Hinges were attached during the process.   In the case of

the plastic temples, heated wires were inserted into the temples

in order to enable them to hold adjustments to their shape.    As a

final step to B&L's fabrication of plastic frames, the plastic



15
   B&L also conducted some aspects of its sunglass operations in
Oakland, Maryland.
                                - 13 -


temples or fronts were placed into a tumbling barrel, which

contained wooden chips and wax to round their edges and polish

them.

     B&L worked hard to ensure the quality of its sunglasses

during both the fabrication of parts for sunglasses and the

assembly of those parts into finished sunglasses.     Regardless

where the parts were fabricated and assembled into finished

sunglasses, B&L maintained strict quality standards and specifi-

cations that the parts and finished sunglasses were required to

meet.     Specifications for all sunglasses were established by the

specifications group at the B&L Frame Center in Rochester.

Establishment by B&L of New Sunglass Assembly Facilities

        During the 1970s, B&L experienced tremendous growth in its

sunglass sales.     Much of that growth was in international

markets, especially Western Europe and Southeast Asia.     By 1982,

approximately half of B&L's sunglass sales were outside the

United States.     To help meet that demand, B&L increased the

output of its sunglass production facilities in Rochester during

the 1970s and continued to do so during the years at issue.

        Prior to 1982, B&L operated a sunglass assembly facility in

France that it decided to close.     Because of the tremendous

growth of its sunglass sales in Europe and elsewhere, it needed

(1) to replace that facility in order to supply its European

markets and (2) to expand its worldwide sunglass production.
                              - 14 -


Although B&L considered further expanding its sunglass assembly

facility in Rochester and opening sunglass assembly facilities in

other places, it determined that Ireland was the best site for

the establishment of a new sunglass assembly facility.

     The primary reason for the selection of Ireland as a site

for a sunglass assembly facility was the availability of grants

from the Industrial Development Authority of Ireland (IDA) and

other incentives provided by the Government of Ireland.   The IDA,

established pursuant to the Industrial Development Act of 1969,

was responsible for promoting industrial development in Ireland.

Its principal objective was to encourage Irish and foreign

industrialists to establish operations in Ireland.   Although the

IDA helped companies organized in Ireland that did not export

products from Ireland, certain service-industry companies, and

small businesses, it favored those businesses setting up manu-

facturing operations that planned to export products from

Ireland.   The IDA offered a wide range of economic and financial

incentives to firms that established operations in Ireland,

including (1) capital grants in amounts up to 45 percent of the

total cost of plant and equipment and (2) training grants in

amounts up to 100 percent of the expenditures incurred to train

employees.

     On or about June 23, 1982, B&L submitted to the IDA a draft

proposal (IDA draft proposal) for the establishment of a sunglass
                              - 15 -


facility in Waterford, Ireland, to be located in the Waterford

industrial estate in which B&L Ireland's contact lens facility

was located.   The IDA draft proposal was prepared in the format

set forth in the IDA's "Guide to the Submission of Industrial

Proposals".

     On or about October 6, 1982, B&L Ireland and the IDA entered

into an agreement (IDA grant agreement) pursuant to which the IDA

agreed to provide B&L Ireland with (1) capital grants equal to 40

percent of B&L Ireland's (a) annual rent, (b) expenditures for

factory-building modifications, and (c) purchases or leases of

new machinery and equipment and (2) training grants equal to 100

percent of B&L Ireland's training costs.   In order to receive the

capital grants under the IDA agreement, B&L Ireland was required

to follow certain procedures, including filing an auditor's

certificate to verify its actual capital expenditures.   It

received capital and training grants from the IDA by submitting

the required documented claims for such grants.

     Contemporaneous with the IDA grant agreement, B&L Ireland

and the IDA entered into a lease and option agreement (unit 107

lease and option agreement) pursuant to which B&L Ireland leased

and was granted an option to purchase from the IDA unit 107 in

the Waterford industrial estate that had an approximate size of

6,700 square feet.   At the same time, but in a separate agree-

ment, the IDA also agreed to grant a rent subsidy to B&L Ireland
                                - 16 -


with respect to the unit 107 lease and option agreement.

     B&L Ireland entered into additional leases with the IDA.       On

or about April 27, 1983, it executed an agreement to lease unit

102 in the Waterford industrial estate to use as a temporary

storage facility for raw materials.      In 1984, B&L Ireland leased

from the IDA a warehouse facility that had an approximate size of

6,000 square feet.   In late 1987, it moved its sunglass assembly

operations to a new facility that had approximately 19,000 square

feet.16

     B&L Ireland received additional financial incentives from

the Government of Ireland in the form of certain exemptions from

Ireland's corporation tax and its value added tax (VAT).     With

respect to Ireland's corporation tax, Ireland generally exempted

from that tax income earned through export sales of goods manu-

factured in Ireland.   Pursuant to that exemption, B&L Ireland was

relieved of its obligation to pay Ireland's corporation tax with

respect to substantially all, if not all, of its profits from its

sunglass assembly operations.    With respect to Ireland's VAT,

Ireland generally exempted from that tax firms engaged in a

manufacturing business that were importing the goods used in that

business.   Pursuant to that exemption, B&L Ireland was exempt

from VAT on items it purchased from B&L Inc. and B&L GmbH for use


16
   It is unclear from the record whether B&L Ireland leased or
purchased the facility into which it moved its sunglass assembly
operations during 1987.
                              - 17 -


in its sunglass assembly operations in Ireland.

     In addition to incentives provided by the IDA and the

Government of Ireland, B&L considered the following factors in

selecting Ireland as the site for a sunglass assembly facility:

(1) The ability to have goods shipped from Ireland duty-free

within the European Economic Community (EEC) because of that

country's membership in the EEC, (2) Ireland's proximity to North

Africa, the Middle East, and Europe, (3) Ireland's low labor

costs, and (4) economies gained by association with the existing

contact lens facility in Waterford, Ireland.

     In addition to opening a sunglass assembly facility in

Ireland during 1982, B&L decided to open a sunglass assembly

facility in Hong Kong during that year.   During the early 1980s,

B&L Hong Kong experienced rapid growth in the sale of sunglasses

that it purchased from B&L.   Because it experienced long lead

times on finished sunglasses shipped from the United States, B&L

Hong Kong found it necessary to maintain large inventories to

avoid running out of certain SKUs of sunglasses.   The cost of

maintaining large inventories during the early 1980s was high

because interest rates were approximately 18 percent at that

time.   In an effort to reduce costs and improve customer service,

in early 1981, Mr. Y.H. Chan, the managing director of B&L Hong

Kong from 1975 and throughout the years at issue, proposed to

William Godfrey (Mr. Godfrey), the president of B&L Inc.'s
                              - 18 -


Consumer and Ophthalmic International Division,17 that B&L Hong

Kong assemble sunglasses in Hong Kong.   Mr. Godfrey approved the

decision on behalf of B&L Inc. to establish a sunglass assembly

facility in Hong Kong.   His decision was based on the following

factors:   (1) Because the parts for different SKUs of Ray-Bans

were interchangeable, B&L Hong Kong could reduce its finished

goods inventory yet process customer orders faster by assembling

the sunglasses in Hong Kong;18 and (2) because labor and overhead

costs were cheaper in Hong Kong than in the United States, the


17
   The Consumer and Ophthalmic International Division succeeded
the Ophthalmic Division as the division of B&L Inc. responsible
for overseeing B&L Hong Kong.
18
   For example, B&L produced different SKUs of sunglasses that
used the same type of frame, but lenses of different colors.
Lenses of the same design also were used interchangeably in
certain different styles of sunglass frames. Each style of frame
with each color of lens represented a different SKU. If B&L Hong
Kong had not decided to assemble sunglasses in Hong Kong, it
would have needed to maintain a finished goods inventory for
every SKU in order to process orders quickly. By maintaining a
sunglass assembly facility in Hong Kong, B&L Hong Kong was able
to process an order without needing to maintain a finished goods
inventory for every SKU. Rather, it simply needed to maintain an
adequate supply of the interchangeable parts. By way of illus-
tration, if B&L Hong Kong had not conducted assembly operations
in Hong Kong and had estimated that it would sell 100 pairs of
large metals, but had been unable to estimate whether its sales
would be for large metals with green or with gray lenses, it
would have needed to stock 100 finished pairs of each of those
SKUs. However, if B&L Hong Kong were to conduct assembly
operations, it could fill an order for 100 large metals with gray
lenses, 100 large metals with green lenses, or some combination
thereof simply by maintaining 100 pairs of frames for large
metals, 100 pairs of gray lenses, and 100 pairs of green lenses.
Thus, the total number of frames in B&L Hong Kong's inventory
could be less than the number of frames in its inventory if it
maintained enough finished goods inventory to fill those orders.
                              - 19 -


overall cost to B&L to produce a pair of sunglasses was reduced.

     From 1982 through 1987, B&L Hong Kong leased facilities in

the Watt's Industrial Building in Hong Kong for its sunglass

assembly operations.   During the period 1983 through 1985, B&L

Hong Kong leased 1,200 square feet for those operations.    During

1986 and 1987, it increased the amount of space it leased to

8,000 square feet, 4,000 square feet of which was used for

production and 4,000 square feet of which was used as a ware-

house.   B&L Hong Kong leased additional space for offices for

managers and other personnel involved in its sunglass assembly

operations.

     In addition to assembling sunglasses, B&L Hong Kong con-

tinued to act as a marketing and distribution company for other

B&L products, including sunglasses assembled outside of Hong

Kong.

Licenses of Intangibles to B&L Ireland and to B&L Hong Kong

     Pursuant to license agreements, B&L Inc. granted to B&L

Ireland and B&L Hong Kong, respectively, nonexclusive licenses to

use certain technology relating to sunglass assembly.19    Pursu-


19
   Except as stated below, the sunglass assembly operations
conducted by B&L Ireland and by B&L Hong Kong were substantially
the same. The sunglass assembly operations conducted by B&L Inc.
in Rochester with respect to metals, plastics, Wings, and
leathers were substantially similar to the sunglass assembly
operations conducted by B&L Ireland with respect to those styles
of sunglasses and by B&L Hong Kong with respect to those styles
except plastics that B&L Hong Kong did not produce. Even at its
                                                   (continued...)
                              - 20 -


ant to those respective license agreements, B&L Inc. provided to

B&L Ireland and B&L Hong Kong specifications for sunglass assem-

bly, production know-how and training, ongoing technical assis-

tance and support, standard operating procedures, and other

documents and information relating to the sunglass assembly

process.   B&L Ireland and B&L Hong Kong paid royalties to B&L

Inc. for the use of such technology.

     B&L Ireland and B&L Hong Kong were required to assemble B&L

sunglasses in accordance with the specifications for such sun-

glasses established by B&L Inc.   Although B&L Ireland and B&L

Hong Kong were able to recommend changes in the specifications,

they were not free to ignore the specifications established by

B&L Inc.

Management Functions at B&L Ireland and B&L Hong Kong

     B&L Ireland employed between 55 and 66 employees, including

the following supervisors (also known as managers) who were

responsible for the conduct of B&L Ireland's sunglass assembly

operations:   (1) A plant manager who was responsible for ensuring

that the plant was properly sized for the volume of production

the plant was required to generate and for ensuring the coordina-


19
 (...continued)
facilities in Rochester, B&L Inc. treated sunglass assembly as a
separate function from the fabrication of sunglass parts. The
assembly operations at B&L Inc., B&L Ireland, and B&L Hong Kong
received some parts from the same parts warehouse located in
Rochester.
                             - 21 -


tion of the activities of the senior managers who reported to him

or her, (2) a production or manufacturing supervisor who was

responsible for the supervision and organization of plant person-

nel and who ensured that all resources (i.e., equipment and

manpower) were in place and that training was properly undertaken

and reported to the IDA, (3) a materials supervisor who was

responsible for preparing the production plan for the plant and

ensuring that all parts were properly ordered and arrived at the

plant in time for processing, and (4) a quality assurance and

engineering supervisor who was responsible for ensuring that the

parts supplied to the plant and the finished products leaving the

plant met the quality standards that apply to B&L sunglasses.

B&L Ireland also had other management staff who were responsible

for finance and accounting, human resources, and other functions.

The plant manager and the senior management personnel normally

met on a weekly basis as a management team to work on policy or

other issues.

     The management of B&L Ireland was responsible for planning

the production of B&L sunglasses in Ireland.   That process, known

as the production planning process, involved several stages.

Approximately six months prior to the beginning of a fiscal year,

the senior management team met to prepare a production budget.

The production budget was based upon the customer sales and

demand forecasts supplied to B&L Ireland by B&L Inc. and upon
                                - 22 -


instructions from B&L Inc. as to which SKUs B&L Ireland was to be

responsible for assembling.   The production budget was designed

to identify the resources (i.e., the necessary personnel and

sunglass parts) required to meet the production plan.   The next

stage of the production planning process was to prepare the

production forecast.   That occurred approximately three months

prior to the planned production and allowed B&L Ireland to order

the necessary sunglass parts from B&L Inc. and B&L GmbH in time

to begin the required production.    The next phase in the produc-

tion planning process was to prepare a production schedule that

occurred one to two weeks in advance of actual production.    The

production schedule was prepared by the production supervisor and

the materials supervisor and was based on what parts and produc-

tion personnel were available at that time to meet required

production as set by B&L Inc.    Manufacturing orders were issued

from the production schedule.    The manufacturing orders specified

which SKU of sunglasses was to be assembled.   Based on the

manufacturing order, parts were issued to the operator (viz., the

assembler) so that the assembly process could begin.

     B&L Ireland was responsible for hiring its own production

personnel and for negotiating union contracts for its sunglass

assembly operations.   B&L Ireland also retained outside consult-

ing firms (1) to develop a job evaluation system for determining

the relative level of skill required to perform the various
                                - 23 -


functions performed by B&L Ireland (including its contact lens

operations) and (2) to assess the relative level of efficiency

achieved by the employees in its sunglass assembly operations and

to recommend work standards to improve that level of efficiency.

     B&L Ireland maintained a management accounting system for

its sunglass assembly operations that was separate from the

accounting system for its contact lens operations.   The account-

ing system for B&L Ireland's sunglass assembly operations was

based upon standard cost accounting under which standard costs

were established for materials, labor, and overheads, and the

actual costs for those items were compared against those standard

costs to determine any variances.    B&L Ireland prepared monthly

reports based on its accounting system in order to aid it in

monitoring its sunglass assembly operations.   B&L Ireland's cost

accounting system was indicative of a manufacturing company and

not a distribution operation.

     B&L Hong Kong's sunglass assembly operations utilized

between 22 and 31 employees, including the following supervisors

and managers who were responsible for its sunglass assembly

operations:   (1) A managing director who had overall respon-

sibility for B&L Hong Kong's operations (including operations

other than the assembly of sunglasses), (2) a production manager

who was responsible for the overall production of sunglasses,

including quality control, process improvement, manpower alloca-
                                 - 24 -


tion, ordering of the parts for production, and production

scheduling, and (3) an assistant production supervisor and two

group leaders who were responsible for the day-to-day production

operations.    The managing director reported to an employee of B&L

Inc.

       The monthly production plans for B&L Hong Kong were prepared

by the production manager based upon information supplied to him

by B&L Hong Kong's sales and marketing personnel, the amount of

goods on hand, and the customer back orders on hand.    B&L Inc.

did not decide which SKUs of sunglasses B&L Hong Kong was to

assemble or sell.    B&L Hong Kong's management was responsible for

those decisions.    From the monthly production plans that were

based on finished sunglasses, the production manager prepared a

weekly production schedule for each day in each week.    The

production manager also was responsible for ordering parts by

taking into account the sales forecast, customer orders, the

finished goods inventory on hand, the parts on hand, and the

parts on order from B&L Inc.20    Starting in 1984, the parts

orders were prepared by B&L Hong Kong using a computer system

that utilized software developed for B&L Hong Kong by an outside

vendor it had hired.



20
   Prior to placing an actual order for parts, B&L Hong Kong
also prepared a quarterly report that it sent to B&L Inc. in
Rochester to alert it to B&L Hong Kong's expected needs for
parts.
                                - 25 -


     Like B&L Ireland, B&L Hong Kong maintained a management

accounting system based upon standard cost accounting to compare

its actual performance data to its standard budgeted data and

prepared monthly reports based on that system in order to assist

it in monitoring its business.    The production manager was

responsible for establishing the standard costs based on histori-

cal data and time and motion studies.    B&L Hong Kong's cost

accounting system was indicative of a manufacturing company and

not a distribution operation.

Training of Personnel

     When B&L Ireland commenced its sunglass assembly operations

in November 1982, the initial training for operators at B&L

Ireland was provided by an individual employed by B&L Inc. and

lasted approximately three weeks.    Around May 1983, an additional

instructor employed by B&L Inc. provided approximately four weeks

of training to B&L Ireland's sunglass assembly personnel.      B&L

Ireland's personnel also traveled to Rochester to train in the

assembly of new SKUs.

     Shortly after commencing operations, B&L Ireland hired

quality assurance inspectors to inspect the finished sunglasses

it assembled.   The initial training for inspectors was provided

by an individual employed by B&L Inc. in the United States.

Approximately 80 percent of the sunglasses produced at the B&L

Ireland sunglass assembly facility during the initial stages of
                              - 26 -


production failed a quality inspection and were returned to the

original operator for reworking.

     B&L Ireland undertook a number of steps to improve the

quality of the sunglasses it produced.   In May 1983, B&L Ireland

established its own training program to ensure that its employees

were competent to produce quality sunglasses.   At that time, B&L

Ireland employed one of its quality assurance auditors to serve

as a full-time instructor.   During 1985, B&L Ireland hired a

second full-time instructor to become an instructor in assembling

metal sunglasses.

     In a further effort to improve the quality of the sunglasses

it assembled and in order to help B&L Ireland establish standard

operating procedures for its sunglass assembly operations, during

1984, B&L Ireland's sunglass assembly operations underwent a

quality audit performed by the quality manager of its contact

lens operation.   Shortly thereafter, the quality assurance

manager for the sunglass assembly operations was replaced.    In

its production budget for its second year of operations (viz.,

1984), the management of B&L Ireland also reduced the estimated

number of SKUs to be produced by it as part of its continuing

effort to improve the quality of the sunglasses it assembled.

     B&L Ireland's training program for operators lasted 13

weeks.   When a new operator started, the instructor showed that

person the workstation and told that person the names of the
                               - 27 -


parts, tools, and equipment he or she was to use.    For the first

week of training, the new operator assembled parts that had been

rejected by the quality assurance personnel.    Beginning in the

second week of training, the new operator started to assemble

sunglasses from parts that had passed inspection as acceptable

for use in B&L sunglasses.    The new operator received one-on-one

instruction in assembly techniques from an instructor.    The time

that the instructor spent with the new operator decreased as the

training period progressed.

       Beginning in the second week of the training program, the

new operator was given targets for the quantity and quality of

sunglasses to be assembled.    For fully-trained operators, B&L

Ireland established a target for assembly of 200 sunglasses per

day.    The target during the second week of instruction was

approximately 25 percent of that amount or 50 sunglasses per day.

During the first few weeks of training, the percentage of salable

sunglasses assembled by the typical new operator was very low.

The typical new operator was able to produce only approximately

70 percent of B&L Ireland's established target of 200 sunglasses

per day at the end of the training period.    Typically, an oper-

ator required approximately six months of assembly experience

prior to reaching the target set by B&L Ireland.

       Some operators were not able to reach a sufficient level of

proficiency to continue to function as operators and were trans-
                               - 28 -


ferred to other functions such as packaging and washing.    Not all

operators were proficient at assembling all types of sunglasses.

Whenever an operator began assembling a new style of sunglasses,

the operator was given additional training until that person was

comfortable and was able to produce sunglasses of sufficient

quality.   If an operator switched from assembling plastics to

assembling metals, the operator was given an additional 13 weeks

of training.

     Training for inspectors at B&L Ireland lasted 13 weeks,

regardless whether the individual being trained had been an

operator prior to that time.    An additional 13 weeks of training

was required if the inspector switched from the inspection of

metals to the inspection of plastics.

     Training for other functions, such as packaging and washing,

lasted four weeks.   When B&L Ireland began applying leather to

metal frames in 1986, the training for the leather application

process lasted eight weeks.    B&L Ireland conducted retraining

programs for operators who were having difficulty meeting quan-

tity and quality standards.    Those programs typically lasted four

weeks.

     Most quality problems at B&L Ireland with respect to the

basic SKUs tended to disappear over time as B&L Ireland's manage-

ment and operators became more experienced in assembling those

types of sunglasses.   However, as new styles of sunglasses were
                               - 29 -


added to B&L Ireland's products, new quality problems arose.

     Like B&L Ireland, before becoming fully operational, B&L

Hong Kong underwent an initial period of training those involved

in the sunglass assembly operations.    Employees of B&L Hong Kong

went to Rochester to observe B&L Inc.'s assembly operations, and

employees of B&L Inc. traveled to Hong Kong to help train employ-

ees of B&L Hong Kong.    B&L Hong Kong also established a pilot

program in which its employees assembled sample batches of

sunglasses to send to B&L Inc. in Rochester for approval.    Just

as B&L Ireland experienced quality problems in the early stages

of its operation, B&L Hong Kong was unable to meet its quality

standards during 1983.

     Unlike B&L Ireland, B&L Hong Kong did not hire any full-time

instructors.   Rather, training of new operators, inspectors, or

other production personnel was handled by B&L Hong Kong's assis-

tant production supervisor and group leaders.    A new operator

received one-on-one supervision for the first two or three weeks

of training to teach that person the basic techniques of assem-

bling sunglasses.   An inspector kept track of the defective

sunglasses assembled by the new operator in order to determine

the areas in which the new operator needed to improve.

     The typical new operator achieved B&L Hong Kong's basic

daily productivity target of 150 units per day within four to six

weeks after the commencement of the training program.    During the
                                - 30 -


first few weeks of training, the percentage of salable sunglasses

assembled by the typical new operator was very low.    A typical

operator became skillful in the assembly of basic SKUs of sun-

glasses within nine to twelve months, but was not able to reach

B&L Hong Kong's average output of 380 pairs of sunglasses per

operator per day until sometime during that person's second year

of employment.   Some new operators failed to reach the minimum

target level and were transferred to other areas.

     Most inspectors at B&L Hong Kong started as operators and

received an additional six to eight weeks of training to become

qualified inspectors.

Purchase of Parts by B&L Ireland and by B&L Hong Kong

     B&L Ireland and B&L Hong Kong purchased from B&L Inc. metal

fronts and temples, glass lenses, screws, packaging materials,

and other parts and materials that they used in their respective

sunglass assembly operations.    B&L Ireland also purchased metal

fronts and temples from B&L GmbH and plastic fronts and temples

from B&L Inc.    During 1987, B&L Ireland purchased nylon frames

from Bolle, a French company unrelated to B&L, that B&L Ireland

used to assemble Cats sunglasses.    B&L Ireland assembled and sold

no more than 35 pairs of Cats during 1987.

     The amounts paid by B&L Ireland and by B&L Hong Kong to B&L

Inc. and by B&L Ireland to B&L GmbH for fronts, temples, lenses,

and other materials used in their respective sunglass assembly
                                - 31 -


operations were equal to B&L Inc.'s and B&L GmbH's respective

standard costs of such parts or materials plus (1) 15 percent in

1983, (2) 20 percent in the first six months of 1984, and (3) 30

percent for the remainder of 1984 through 1987.    Both B&L Ireland

and B&L Hong Kong communicated with their suppliers (i.e., B&L

Inc. and B&L GmbH with respect to B&L Ireland and B&L Inc. with

respect to B&L Hong Kong) to identify and improve quality prob-

lems with respect to the parts they purchased from them.

     B&L Ireland and B&L Hong Kong were responsible for managing

and controlling the parts and materials used in their respective

sunglass assembly operations.    Each company maintained part

numbers for each of the parts and materials that it purchased and

used those part numbers for inventory control and management

purposes.   B&L Ireland and B&L Hong Kong typically received parts

in boxes containing 50 or more units of a single item (i.e., a

single part number).   Each box of 50 or more units was referred

to as a lot.

     At B&L Ireland, the quality assurance department inspected

purchased parts (incoming inspection) to screen out nonconforming

or defective parts, identify problems that might arise during the

production process, and identify opportunities to work with its

suppliers to improve quality.    To perform the incoming inspec-

tion, a trained inspector selected a random sample of parts from

each lot, examined the parts visually and with various gauges and
                               - 32 -


tools to identify cosmetic or aesthetic defects and dimensional

defects, and marked each defective part.   The inspector compared

the total number of rejected parts to a standard to determine

whether the lot passed or failed the incoming inspection.    If too

many of the purchased parts of a particular lot were determined

to be defective, the inspector placed the failed lot in quaran-

tine.21   If the purchased parts passed inspection, B&L Ireland's

materials management department stored the parts in inventory

until they were needed for assembly.

     At B&L Hong Kong, the incoming inspection was performed by

each operator who was trained and responsible for checking the

parts prior to assembling them to ensure that they were of

acceptable quality for assembly.   If the operator found any

defects, he or she was to ask the storekeeper to exchange the

defective parts for nondefective parts.    The storekeeper, who was

also trained to perform quality inspections, verified whether

those parts submitted by the operator were in fact defective.    If

they were defective, the storekeeper replaced them; if they were

not defective, the storekeeper returned them to the operator for

assembly.   B&L Hong Kong employed an individual to repair repair-

able defective parts so that those parts could be used to as-


21
   Parts placed in quarantine by B&L Ireland were not used for
assembling sunglasses unless absolutely necessary. If it became
necessary to use the quarantined parts, those parts were in-
spected to sort out the unusable parts. Quarantined parts were
sometimes reworked to make them acceptable before they were used.
                              - 33 -


semble sunglasses.

     Even if the parts purchased by B&L Ireland and by B&L Hong

Kong had passed the incoming inspections conducted by each of

those companies, an operator still could have experienced some

difficulty in assembling those parts due to a problem known as

tolerance stacking.   Because the incoming inspections at both B&L

Ireland and B&L Hong Kong tested to established tolerances,

purchased parts were permitted to deviate from the nominal

specification (viz., the ideal size) for those parts within a

certain range and nonetheless pass inspection.    For example, if

an operator had attempted to insert a lens that was larger than

the nominal specification into a frame that was smaller than the

nominal specification, the operator may not have been able to

assemble those parts correctly.

Metals

     At both B&L Ireland and B&L Hong Kong, the operator received

the parts to be assembled along with a manufacturing order

detailing the SKU to be assembled.     The operator began assembling

the metals by picking up a front and using a screwdriver to open

the left and right lens screws in the endpieces on the fronts by

turning them three revolutions to permit the operator to attempt

to insert the lenses properly without damaging the lenses or the
                                - 34 -


front.22    The operator manipulated the right and left lenses into

the respective eyewires of the front in a manner intended to

avoid canted eyes (i.e., improper rotation and seating of the

lenses in the fronts), partially assembled sunglasses (on which

the lens could pop out after the lens screw had been tightened),

and chipped or scratched lenses.     If the lens had been larger

than the nominal specification for lenses, or the frame had been

smaller than the nominal specification for frames, the operator

might have had to turn the lens screw more.     If the operator had

opened the lens screw too far, the screw might have popped out of

the hole and the operator would have had to begin the process

again.     On the other hand, if the operator had not opened the

lens screw far enough, the operator, by applying too much pres-

sure trying to force the lens into place, might have chipped the

lens, which would have caused the lens to be rejected as unac-

ceptable for use in B&L sunglasses.

     After inserting the lenses, the operator inserted a temple

into the endpiece of the front, aligning the holes of the temple

with the holes of the endpiece.23    The operator maintained that

alignment with one hand and picked up a tiny screw that was 2.5

to 3 millimeters in length and .5 to 1 millimeter in diameter and


22
   B&L and we refer to the process of inserting lenses into the
fronts as lensing.
23
   B&L and we refer to the process of attaching the temple to
the front as templing.
                               - 35 -


inserted it into the temple.   Using a screwdriver, the operator

partially tightened the temple screw, fully tightened the lens

screw, and fully tightened the temple screw.   The operator

repeated the templing process with respect to the other temple.

If the operator had applied too much pressure to the screws when

tightening them, the following damage, any of which would have

made the affected part unacceptable, might have occurred:     (1) A

cracked lens, (2) a chipped lens, (3) stripped or chipped screw

head, (4) stripped screw threads, (5) stripped threads inside the

temple or endpiece holes, and (6) broken solder on the endpiece.

     Following completion of the lensing and templing procedures,

the operator inspected the sunglasses for any damage to the parts

that occurred during the assembly process and replaced any

damaged parts identified.

     The operator inspected both the left and right lens for lens

gaps (i.e, a gap between the lens and the frame).   If the oper-

ator had identified a lens gap, the operator would have adjusted

the curvature of the frame by manually bending the frame to meet

the curvature of the lens.   B&L Ireland and B&L Hong Kong fre-

quently encountered lens gap problems with respect to a style of

metals called Caravans that had square rather than round eye-

pieces.   This was because the curvature of the top of the Caravan

frame generally failed to meet the curvature of the lens.     At B&L

Ireland, operators were responsible for adjusting the curvature
                              - 36 -


of the Caravans prior to assembly.     At B&L Hong Kong, an in-

dividual known as a repairer was assigned to adjust the curvature

of the Caravan frames before they were given to the operators for

assembly.

      The operator used an eyewire to identify any endpiece gap

(i.e., a gap between the top and bottom portions of the

endpiece).   If the operator had identified an unacceptable

endpiece gap, the operator would have used gapping pliers to

apply pressure to the endpiece so that he or she could have

further tightened the lens screw.    If the operator had applied

too much pressure to the pliers, he or she could have chipped the

lens or broken the solder on the endpiece.

     The operator used a fitback board to identify and examine

the crossover angle (i.e., the angle of the temples when folded

in relation to a horizontal line joining the hinge centers), the

fitback angle (i.e., the angle formed by the temples in an open

position in relationship to the front), and the down angle (i.e.,

the angle formed by the front and temple in the open position) in

order to determine if those angles were within the specifications

established for the SKU being examined.     The operator also used

the fitback board to determine whether there were any rocking

temples (i.e., whether both temples had contact with the surface
                              - 37 -


when lying topside down on a flat surface).24   If the operator

had determined that an adjustment to the sunglasses was needed,

the operator would have used truing pliers to manipulate the

endpiece to the required angle.   If the operator had applied too

much pressure or otherwise misused the pliers when bending the

endpiece, the operator could have broken or marked the endpiece

or the temple, or chipped the lens.    If an adjustment had been

made, all angles would have been rechecked until no further

adjustment would have been necessary.

     After the operator completed the truing process, the sun-

glasses were sent to trained inspectors at B&L Ireland and B&L

Hong Kong who performed an inspection of each pair of assembled

sunglasses to ensure that it conformed to the specifications for

the SKU being inspected (100-percent inspection).    Specifically,

the inspectors (1) inspected the temples and fronts for cosmetic

defects; (2) examined the crossover, fitback, and down angles and

made any necessary adjustments to the sunglasses; (3) determined

whether there were any rocking temples and made any necessary ad-

justments to eliminate them; (4) adjusted the nosepads; (5) ex-

amined the lenses for cosmetic defects (including any defects in

the trademark and logo markings) by (a) identifying any chips,

scratches, or digs, (b) measuring any such defects using a


24
   B&L and we refer to the processes of examining and adjusting
the various angles and determining the presence of and eliminat-
ing rocking temples as truing.
                             - 38 -


scratch and dig plate, and (c) comparing any such defects to the

standard allowable size and number of such defects that varied

depending on the location of the defects and the SKU being

assembled; (6) examined the sunglasses for the presence of any

lens gaps and canted eye or other fit defects and made any

necessary adjustments to eliminate them; (7) inspected the

endpieces for endpiece gaps and screw quality; (8) identified any

rejected sunglasses and made the necessary repairs and/or re-

placements to those sunglasses; and (9) cleaned the sunglasses

with their gloves.

     Following the 100-percent inspection, washers placed the

inspected metal sunglasses at B&L Ireland and at B&L Hong Kong in

a rack, washed the sunglasses in chemicals, rinsed the sunglasses

with Freon, placed the sunglasses in a drying chemical, and

placed the dried sunglasses into another rack.

     After inspection and cleaning functions, packers packed each

pair of inspected sunglasses at B&L Ireland and at B&L Hong Kong.

The packer determined if any special packing material was neces-

sary by reference to a special packing manual, placed a hang tag

on the left temple if specified, closed the left and right

temples, placed the sunglasses in a case, and placed the speci-

fied quantity in a finished goods box.   After completing the

packing process, the packer verified the quantity in the box and

completed a quality sheet.
                               - 39 -


     At B&L Ireland, the auditors, who were trained inspectors,

performed an audit of the finished sunglasses that had been

packaged to ensure that the products conformed to B&L's stan-

dards.   The auditor selected a random sample of the sunglasses

from a particular lot and performed inspection functions with

respect to that sample similar to the 100-percent inspection

performed by inspectors.    If the auditor had identified too many

defects in the samples inspected, the lot would have failed the

audit.   In that event, all the sunglasses in the lot would have

been returned to the inspector for another 100-percent inspec-

tion, and the inspector would have corrected any defects iden-

tified and would have sent the lot back to the auditor for

reauditing.

     B&L Hong Kong did not have any personnel devoted solely to

carrying out the audit function with respect to finished sun-

glasses.    Its cleaners, who cleaned each sunglass unit with a

hand cloth following the washing process, and its packers were

trained in inspection procedures needed to perform the audit

function.   The cleaners and packers performed inspection func-

tions similar to the inspections conducted by B&L Ireland's

auditors.   However, rather than inspecting only a random sample

of each lot, each pair of sunglasses at B&L Hong Kong received a

second inspection conducted by the cleaners and packers.

Plastics
                              - 40 -


     In addition to assembling metals, B&L Ireland's personnel

assembled plastics.   B&L Hong Kong did not perform any operations

that resulted in plastic sunglasses and did not even sell many

B&L plastic sunglasses assembled outside B&L Hong Kong.    This was

principally because the bridge on the plastics was too wide for

the average Asian face, which tended to be smaller than the

average Caucasian face, and, unlike metals, plastics did not have

nosepads that could be adjusted to fit the Asian face.

     In assembling plastics, B&L Ireland's personnel used a

heating tunnel equipped with temperature and speed controls in

order to render the plastic fronts sufficiently malleable so as

to permit the insertion of the lenses and the formation of the

headcurve of the fronts.   The heating tunnel, which contained a

conveyor belt running through the machine, heated the front with

electrical elements located on the top of the tunnel.    Although

the specifications for a particular SKU established initial

settings for the temperature and speed, the operator was respon-

sible for adjusting those controls as necessary to facilitate the

lensing process.   If a front had not been hot enough when it

exited the tunnel, the operator could not have inserted both

lenses without damaging either the fronts or the lenses.   On the

other hand, if the front had been too hot when it exited the

heating tunnel, it could have suffered heat damage such as sunken
                              - 41 -


plaques,25 bubbles, blisters, and cracks.

     After the operator removed the heated front from the heating

tunnel, he or she removed the plastic protective caps from the

hinges with a decapper or pliers, placed the front on the metal

stretcher plate located on a pneumatic stretcher machine, and

activated the machine that compressed a top plate down on to the

stretcher plate, thereby stretching the eye cavities on the front

and partially forming the headcurve of the front.   The operator

removed the front from the stretcher plate, manipulated the

lenses into the eye cavities, manipulated the front to form the

proper headcurve for the SKU being assembled, measured the

headcurve using a headcurve chart, examined the fronts for

distortions, and checked for and corrected any lens gaps or other

defects.   The operator was required to complete the lensing

process before the front cooled down.

     Prior to attaching the plastic temples to the fronts, the

operator was required to use a mitring machine to cut plastic

from the front end of the temples so as to create an angle that

conformed to the angle of the front.26   The operator adjusted the

cutting blade of the mitring machine, inserted and aligned a



25
   The plaque is the metal piece on the plastic front. It
appears sunken when the plastic around the metal becomes so hot
that it swells and covers the plaque.
26
   B&L and we refer to the process of cutting the temples with a
mitring machine as mitring.
                               - 42 -


temple so that the machine would cut the temple, and secured and

cut the temple.    If the operator had cut off too much plastic,

the temple would have been scrapped.    If the operator had cut off

too little plastic, the process would have been repeated.

     After mitring the temple, the operator attached the temple

to the front.    He or she performed that function by inserting a

temple into the endpiece of the front, aligning the temple holes

with the endpiece holes, and, while maintaining that alignment

with one hand, picking up and inserting a tiny screw into the

temple hole with the other hand, and fully tightening the screw.

The process was repeated with respect to the other temple.

     During certain periods from 1985 through 1987, operators at

B&L Ireland used a semiautomatic screwdriver to perform the

templing process with respect to plastic sunglasses.    The

operator aligned the temple and front and placed those parts on

the stand of the semiautomatic screwdriver.    The operator then

pressed a footpedal attached to that screwdriver that resulted in

securing a screw, inserting it into the temple holes, and fully

tightening it.    The process was repeated with respect to the

other temple.

     After completing the templing process with respect to three

units in a lot, the operator performed a truing process on the

plastic sunglasses similar to the one conducted with respect to

metal sunglasses.    If the mitring on those three units had been
                               - 43 -


done properly, the operator would have completed the templing

process with respect to the remainder of the lot.   If the mitring

had not been done properly, the temples would have been remitred

if possible, or if not, they would have been scrapped and

replaced.

     When necessary, operators at B&L Ireland removed cosmetic

blemishes from plastic sunglasses using a polishing machine that

had a spinning wheel with surfaces for polishing and buffing.

The operator held the blemish, which was marked with a yellow

grease pencil, to the polishing surface until it could not be

seen (or it was determined that the blemish could not be re-

moved).    The operator used the buffing surface to remove the

polish from the lenses.

     After the operator completed the lensing, mitring, templing,

truing, inspection, and any repair functions, the lot was sent to

the inspectors for a 100-percent inspection.    They performed an

inspection with respect to plastics that was similar to the

inspection performed with respect to metals.    If the sunglasses

passed the inspection, they were packed and audited in a manner

similar to the respective packing and auditing functions per-

formed with respect to metals.

Leathers

     During 1984 through 1987, personnel at B&L Ireland and at

B&L Hong Kong performed lensing, templing, truing, inspections,
                               - 44 -


packing, and audit processes with respect to leathers that were

substantially similar to those processes with respect to metals.

      Beginning in 1986 and during 1987, B&L Ireland and B&L Hong

Kong applied leather to metal fronts (including headbars) and

temples prior to completing the lensing, templing, and truing

functions.   Those companies used a training manual prepared by

Tannereye Ltd., an unrelated company, to train their employees to

perform those functions.

      In the leather application process during 1986 and 1987, the

operator mixed the ingredients for the primer, applied the primer

to the fronts27 using a syringe, and placed the primed fronts and

temples in a drying area for a minimum of eight hours (or, in the

case of black chrome fronts, placed them in an oven for two

hours, reprimed the fronts, and allowed them to dry for 24

hours).   The operator used acetone to remove primer from the

endpieces or bridge, since those areas had to be free of any

adhesive that would detract from their appearance.

      Prior to applying leather to the primed fronts, the operator

inspected the leather, which had an inactive glue on the inside

surface, to ensure that it was free from flaws.   The operator

measured the leather (including marking where the nosepad arm was

located) and cut off any excess leather so that the leather piece

would fit the front.   The operator applied acetone to the side of


27
     Primer was also applied to metal temples.
                                - 45 -


the leather with the glue on it to activate the glue and applied

the leather to the front.     The operator (1) used a soldering iron

to burn off any excess thread; (2) used modeling tools to press

the leather down to avoid gaps where the metal was showing; and

(3) placed the front in a pressurized trap that pressed the

leather tightly against the front to avoid problems with loose

leather that was not secured to the front.     After the operator

examined the fronts for defects in the leather application and

corrected any defects, the operator applied nosepads to the

leather fronts.

     In order to apply leather to the headbar of the metal

fronts, the operator applied pressure to the headbar to deform

the front to allow room to apply the leather to the headbar.       The

operator applied the leather to the headbar in a manner similar

to that performed with respect to the application of leather to

the fronts.     When the leather was applied to the headbar, the

operator pushed the headbar back into place to re-form the front.

     The operator applied leather to temples in a manner similar

to that performed with respect to fronts.     After applying the

leather to the temples, the operator used a vice to bend the

temples in order to form the required curve in the temples for

the SKU being assembled.

Wings

        From 1984 through 1987, personnel at B&L Ireland and at B&L
                                - 46 -


Hong Kong performed templing, truing, inspection, packaging, and

audit processes with respect to Wings that were similar to those

processes performed with respect to metals.    However, Wings

required a different lensing technique because, unlike metals

that had two separate glass lenses, Wings had a lens consisting

of a one-piece plastic shield.    In the case of Wings, after

opening the screws and working the eyewire around the lens, the

operator inserted Wings pliers, one side of which was plastic and

the other side of which was rubber, between the nosepad and the

front and exerted pressure until the lens snapped into place.

Due to the design of the Wings lens, B&L Ireland and B&L Hong

Kong experienced more lens gap problems in the nasal area of

Wings than they experienced with most other styles of sunglasses.

In an attempt to minimize the lens gap, B&L Ireland developed and

used an adjusting tool known as the Wings Gap Eliminator.

     After completing the truing process with respect to Wings

sunglasses, operators at B&L Ireland and B&L Hong Kong washed

those sunglasses in a hot water bath and a cold water rinse to

remove a protective coating from the lenses that was intended to

prevent scratching.

Sales of Sunglasses Assembled by B&L Ireland and by B&L Hong Kong

     B&L Ireland and B&L Hong Kong assembled the following styles

and quantities of sunglasses:
                                 - 47 -


                               B&L Ireland

     Description     1983        1984         1985     1986          1987

     Metals        721,000    406,828     450,325   391,250       536,872
     Plastics                   529         520   169,434       257,378
     Wings                     54,657      50,125    15,093        24,661
     Leathers                 171,469      65,694    43,607        77,207
     Others28                     165                44,287       192,912
        Total      721,000    633,648     566,664   663,671     1,089,030

                              B&L Hong Kong

     Description     198329      1984         1985     1986          1987

     Metals                   383,860     426,546    428,012    456,312
     Leathers                  38,391      42,545     35,902     39,176
     Wings                     18,528      26,379     16,085      4,078
     Others                                            8,008      3,701
        Total      452,262    440,779     495,470    488,007    503,267

       B&L Ireland transferred the sunglasses it assembled to a

distribution warehouse located in Culembourg, Holland.         B&L

Ireland did not maintain a sales or marketing staff.          The market-

ing for B&L Ireland was handled by Bausch & Lomb United Kingdom

(B&L United Kingdom) in London.     The sunglasses assembled by B&L

Ireland were sold primarily for distribution in Europe and the



28
   The category "Others" primarily included styles called Clas-
sic Colours and Precious Metals. Those styles were metals that
were coated with sprayed-on paint in the case of Classic Colours
or with a coating of rhodium and ruthenium in the case of Pre-
cious Metals. B&L Ireland experienced some difficulty in assem-
bling Classic Colours and Precious Metals because the coatings on
those styles, which were applied by a third party, chipped off
very easily.
29
   The record does not disclose the breakdown of the styles of
sunglasses assembled by B&L Hong Kong during 1983.
                              - 48 -


Middle East.   Most of its European customers were B&L subsidiar-

ies that operated warehouses in most of the European countries.

In the Middle East, most of B&L Ireland's customers were inde-

pendent distributors that sold other products in addition to Ray-

Bans.   B&L Ireland did not sell any sunglasses in Ireland.

      Not all of the B&L sunglasses sold in Europe and the Middle

East were assembled at the B&L Ireland sunglass assembly facili-

ty.   B&L Ireland tended to manufacture SKUs of the biggest

runners (i.e., the best selling styles of sunglasses) so that it

was not required to train employees to assemble those products

that were in less demand.

      B&L Hong Kong sold the sunglasses it assembled for distribu-

tion in Southeast Asia.   It sold sunglasses directly to retail

optical shops in Hong Kong and sold to both related and independ-

ent distributors for distribution in the remainder of Southeast

Asia.   In addition to selling the sunglasses it assembled, B&L

Hong Kong sold B&L sunglasses not assembled by it as well as

other B&L products.

      In general, B&L Ireland and B&L Hong Kong sold sunglasses at

prices equal to the international distributor list price (1) less

25 percent for related distributors and (2) less 10 to 15 percent

for unrelated distributors.

      Neither B&L Ireland nor B&L Hong Kong assembled sunglasses
                              - 49 -


for distribution in the United States.   Nor did either company

sell sunglass parts to retailers except as replacements for

repair work.   Neither B&L Inc., B&L Ireland, B&L Hong Kong, nor

anyone else in the sunglass industry sold sunglass parts to the

ultimate consumer.

Tax Return Treatment

     For each year at issue, petitioners reported none of the

income of B&L Ireland and of B&L Hong Kong from the sale of

sunglasses they assembled as income under subpart F of the Code

(subpart F).

     For each of their taxable years ended December 30, 1984,

December 29, 1985, and December 28, 1986, petitioners reported

certain of B&L Hong Kong's income from sources other than the

sale of sunglasses assembled by it as subpart F income.30   Petit-

ioners did not report any of B&L Hong Kong's income as subpart F

income for its taxable year ended December 25, 1983.   A memoran-

dum prepared by B&L in connection with the tax audit of petition-

ers' taxable years ended December 25, 1983, and December 30,

1984, indicated that petitioners did not report any of B&L Hong

Kong's income as subpart F income for their taxable year ended

December 25, 1983, because that company "generated an overall

loss from subpart F operations" for that year.


30
   It is not clear from the record what all of the sources of
B&L Hong Kong's reported subpart F income were for those years.
                              - 50 -


Polaroid

     From 1960 through the early 1980s, Sidney P. Davis (Mr.

Davis) was an employee of Polaroid U.K., which marketed and

distributed sunglasses in the United Kingdom.    At the time he

joined Polaroid U.K., it sold sunglasses that were assembled for

it by Polarizer U.K., an unrelated company, from lenses that

Polaroid U.K. imported from the United States and from frames

purchased by Polaroid U.K.   After joining Polaroid U.K., Mr.

Davis, acting as a representative of that company, became the

production manager of the assembly operations conducted by

Polarizer U.K.   His work included improving the quality control

of the vendors supplying frames and training the Polarizer U.K.

staff in quality control procedures.   In Mr. Davis' view, the

Polarizer U.K. factory in which he worked was a manufacturing

unit engaged in production, and he was a manufacturing manager.

     The assembly operations conducted by Polaroid U.K. and

Polarizer U.K. throughout the period during which Mr. Davis was

production manager were very similar to the assembly operations

conducted by B&L Ireland and by B&L Hong Kong.    Parts were pur-

chased, sorted, and inspected.   The parts were assembled into

finished sunglasses with each operator responsible for quality

control.   The finished sunglasses underwent a final inspection

before they were shipped.
                              - 51 -


                              OPINION

Evidentiary Matters

     We deal first with the admissibility of certain facts and

exhibits to which the parties stipulated, but as to which the

parties preserved evidentiary objections in the stipulations of

facts.   At trial, we admitted those facts and exhibits into

evidence conditionally, subject to our ruling on their admis-

sibility.

     The bases for most of the objections in the stipulations of

facts are that certain stipulated facts and exhibits are inadmis-

sible under rule 402 of the Federal Rules of Evidence because

they are not relevant as defined in rule 401 of those rules and

that, if such facts and exhibits are relevant, they are in any

event inadmissible under rule 403 of those rules.   We have

examined each of the stipulated facts and exhibits in question

and find each of them to be relevant.   Fed. R. Evid. 401.    In

addition, we find that the probative value of each of those facts

and exhibits outweighs any potential for unfair prejudice,

confusion, or other basis for inadmissibility stated in rule 403

of the Federal Rules of Evidence.   Accordingly, we overrule all

of the parties' evidentiary objections based on rules 401, 402,

and 403 of the Federal Rules of Evidence.

     Each party also objected in the stipulations of facts to
                              - 52 -


certain stipulated exhibits on grounds of hearsay.    "'Hearsay' is

a statement, other than one made by the declarant while testify-

ing at trial or hearing, offered in evidence to prove the truth

of the matter asserted."   Fed. R. Evid. 801(c).   Petitioners

objected to the following exhibits on those grounds:    (1) "The

Story of Bausch & Lomb", (2) "articles from a 'manufacturing

journal' prepared by Petitioners", (3) two "newspaper articles"

from "Democrat and Chronicle, July 20, 1987" and "USA Today, May

6, 1987", (4) "Bausch & Lomb Magazine, Vol. 4, No. 3, dated

September 1987", (5) "advertisements that appeared in Boating

Monthly, a Hong Kong Yachting Association publication, dated

November 1979", and (6) "a document prepared by petitioners".      We

find that, with the exception of the two newspaper articles,

petitioners and/or their agents prepared the exhibits in question

and that they are admissions by a party opponent within the

meaning of rule 801(d)(2) of the Federal Rules of Evidence that

are not hearsay.   We find that the two newspaper articles in

question are hearsay as defined in rule 801 of those rules, and

respondent has not argued that any exception to the hearsay rule

applies to those articles.

     Respondent objected to one paragraph of a "memorandum from

D.L. McGinnis to D. Earhart, dated November 14, 1979" (McGinnis

memorandum) on the ground that it is hearsay included within
                              - 53 -


hearsay that is not otherwise admissible pursuant to rule 805 of

the Federal Rules of Evidence.   The paragraph at issue in that

memorandum, viz., the third narrative paragraph that begins

"Regarding salaries", relates D.L. McGinnis' notes from a conver-

sation that he had with another individual concerning the availa-

bility of training grants from the IDA for B&L Ireland's contact

lens operations.   We find that that paragraph constitutes hearsay

within hearsay not otherwise admissible pursuant to rule 805 of

the Federal Rules of Evidence.

     In conclusion, the two newspaper articles and the third

paragraph of the McGinnis memorandum are inadmissible hearsay.

We unconditionally admit into evidence the remaining stipulated

facts and exhibits to which the parties objected and make them

part of the record in these cases.

Foreign Base Company Sales Income--Section 954(d)(1)

     Under subpart F (sections 951 through 964), a U.S.

shareholder of a CFC must include in gross income a pro rata

share of certain classes of income of that CFC including, inter

alia, foreign base company sales income.31   Section 954(d) pro


31
   Sec. 951(a)(1) provides that a U.S. shareholder of a CFC must
include in gross income, inter alia, a pro rata share of the sub-
part F income of that CFC for the year ended during such share-
holder's tax year. Sec. 952(a) defines the term "subpart F in-
come" to include "foreign base company income". Sec. 952(a)(2).
Sec. 954(a) defines "foreign base company income" to include
                                                   (continued...)
                             - 54 -


vides in pertinent part:

     (d) Foreign Base Company Sales Income.--

          (1) In General.--For purposes of subsection
     (a)(2), the term "foreign base company sales income"
     means income (whether in the form of profits, commis-
     sions, fees, or otherwise) derived in connection with
     the purchase of personal property from a related person
     and its sale to any person * * * where--

               (A) the property which is purchased * * * is
          manufactured, produced, grown, or extracted out-
          side the country under the laws of which the con-
          trolled foreign corporation is created or organiz-
          ed, and

               (B) the property is sold for use, consump-
          tion, or disposition outside such foreign country
          * * *.

     The legislative history of subpart F provides some guidance

on the meaning of foreign base company sales income.   In its

explanation of subpart F, the Senate Finance Committee stated:32

          The "foreign base company sales income" referred
     to here means income from the purchase and sale of
     property, without any appreciable value being added to
     the product by the selling corporation. This does not,
     for example, include cases where any significant amount
     of manufacturing, major assembling, or construction
     activity is carried on with respect to the product by
     the selling corporation. On the other hand, activity
     such as minor assembling, packaging, repackaging or
     labeling will not be sufficient to exclude the profits


31
 (...continued)
"foreign base company sales income" as defined in sec. 954(d).
Sec. 954(a)(2).
32
   The House Ways and Means Committee used similar language in
its report on subpart F. H. Rept. 1447, 87th Cong., 2d Sess.
(1962), 1962-3 C.B. 402, 466.
                             - 55 -


     from this definition.

          The sales income with which your committee is
     primarily concerned is income of a selling subsidiary
     (whether acting as principal or agent) which has been
     separated from manufacturing activities of a related
     corporation merely to obtain a lower rate of tax for
     the sales income. * * * [S. Rept. 1881, 87th Cong., 2d
     Sess. (1962), 1962-3 C.B. 703, 790.]

In their technical explanations of the bill enacting subpart F,

both the Senate Finance Committee and the House Ways and Means

Committee further explained that the definition of "foreign base

company sales income":

     does not apply to income of a controlled foreign cor-
     poration from the sale of a product which it manufac-
     tures. In a case in which a controlled foreign cor-
     poration purchases parts or materials which it then
     transforms or incorporates into a final product, income
     from the sale of the final product would not be foreign
     base company sales income if the corporation substan-
     tially transforms the parts or materials, so that, in
     effect, the final product is not the property pur-
     chased. Manufacturing and construction activities (and
     production, processing, or assembling activities which
     are substantial in nature) would generally involve
     substantial transformation of purchased parts or ma-
     terials. [S. Rept. 1881, supra, 1962-3 C.B. at 949;
     H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B.
     at 592-593.]

     Under 954(d)(1), if a CFC purchases property from a related

person that it sells to any person for use or consumption outside

the country under which it is organized, a U.S. shareholder of

that CFC is subject to U.S. income tax on that stockholder's pro

rata share of the income generated by such sale unless the prop-

erty sold is manufactured, produced, grown, or extracted in the
                              - 56 -


country in which the CFC is organized.   If, however, the CFC

manufactures, produces, grows, or extracts the property that it

sells in the country in which it is organized, the income from

the sale of that property is not foreign base company sales

income, regardless where the property is used or consumed.      Dave

Fischbein Manufacturing Co. v. Commissioner, 59 T.C. 338, 355

(1972); see sec. 1.954-3(a)(4)(i), Income Tax Regs.

     Although the terms "manufactured" and "produced" are not

defined by the Code, section 1.954-3(a)(4)(i), Income Tax Regs.,

provides that a CFC will be considered "to have manufactured,

produced, or constructed personal property which it sells if the

property sold is in effect not the property which it purchased."

That regulation further provides that the property sold will not

be considered the property purchased if the provisions of either

section 1.954-3(a)(4)(ii) or (iii), Income Tax Regs., are met.

     Section 1.954-3(a)(4)(ii), Income Tax Regs., provides in

pertinent part:

          (ii) Substantial transformation of property. If
     purchased personal property is substantially trans-
     formed prior to sale, the property sold will be treated
     as having been manufactured, produced, or constructed
     by the selling corporation. * * *

That regulation also includes the following three examples of a

substantial transformation:   (1) Wood pulp into paper, (2) steel

rods into screws and bolts, and (3) fresh fish into canned fish.
                        - 57 -


Section 1.954-3(a)(4)(iii), Income Tax Regs., provides:

     (iii) Manufacture of a product when purchased com-
ponents constitute part of the property sold. If pur-
chased property is used as a component part of personal
property which is sold, the sale of the property will
be treated as the sale of a manufactured product, rath-
er than the sale of component parts, if the operations
conducted by the selling corporation in connection with
the property purchased and sold are substantial in na-
ture and are generally considered to constitute the
manufacture, production, or construction of property.
Without limiting this substantive test, which is depen-
dent on the facts and circumstances of each case, the
operations of the selling corporation in connection
with the use of the purchased property as a component
part of the personal property which is sold will be
considered to constitute the manufacture of a product
if in connection with such property conversion costs
(direct labor and factory burden) of such corporation
account for 20 percent or more of the total cost of
goods sold. In no event, however, will packaging,
repackaging, labeling, or minor assembly operations
constitute the manufacture, production, or construction
of property for purposes of section 954(d)(1). The ap-
plication of this subdivision may be illustrated by the
following examples:

     Example (1). Controlled foreign corporation A,
incorporated under the laws of foreign country X, sells
industrial engines for use, consumption, and disposi-
tion outside country X. Corporation A, in connection
with the assembly of such engines, performs machining
and assembly operations. In addition, A Corporation
purchases, from related and unrelated persons, com-
ponents manufactured in foreign country Y. On a per
unit basis, A Corporation's selling price and costs of
such engines are as follows:

   Selling price.................................. $400
   Cost of goods sold:
     Material--
          Acquired from related
         persons........................ $100
          Acquired from others.............   40
              Total material.................... $140
                        - 58 -


        Conversion costs (direct labor and
          factory burden).......................
        70
              Total cost of goods sold...............
        210
   Gross profit................................... 190
   Administrative and selling expenses............    50
   Taxable income................................. 140

The conversion costs incurred by A Corporation are more
than 20 percent of total costs of goods sold ($70/$210
or 33 percent). Although the product sold, an engine,
is not sufficiently distinguishable from the components
to constitute a substantial transformation of the
purchased parts within the meaning of subdivision (ii)
of this subparagraph, A Corporation will be considered
under this subdivision to have manufactured the product
it sells.
     Example (2). Controlled foreign corporation B,
incorporated under the laws of foreign country X,
operates an automobile assembly plant. In connection
with such activity, B Corporation purchases from re-
lated persons assembled engines, transmissions, and
certain other components, all of which are manufactured
outside of country X; purchases additional components
from unrelated persons; conducts stamping, machining,
and subassembly operations; and has a substantial
investment in tools, jigs, welding equipment, and other
machinery and equipment used in the assembly of an
automobile. On a per unit basis, B Corporation's
selling price and costs of such automobiles are as
follows:

   Selling price................................ $2,500
   Cost of goods sold:
     Material--
          Acquired from related
         persons................ $1,200
          Acquired from others.....     275
              Total material............... $1,475
        Conversion costs (direct labor and
          factory burden)..................    325
              Total cost of goods sold.............
        1,800
   Gross profit.................................    700
   Administrative and selling expenses..........    300
                             - 59 -


        Taxable income...............................    400

     The product sold, an automobile, is not sufficiently
     distinguishable from the components purchased (the
     engine, transmission, etc.) to constitute a substantial
     transformation of purchased parts within the meaning of
     subdivision (ii) of this subparagraph. Although con-
     version costs of B Corporation are less than 20 percent
     of total cost of goods sold ($325/$1,800 or 18 per-
     cent), the operations conducted by B Corporation in
     connection with the property purchased and sold are
     substantial in nature and are generally considered to
     constitute the manufacture of a product. Corporation B
     will be considered under this subdivision to have
     manufactured the product it sells.

          Example (3). Controlled foreign corporation C,
     incorporated under the laws of foreign country X, pur-
     chases from related persons radio parts manufactured in
     foreign country Y. Corporation C designs radio kits,
     packages component parts required for assembly of such
     kits, and sells the parts in a knocked-down condition
     to unrelated persons for use outside country X. These
     packaging operations of C Corporation do not constitute
     the manufacture, production, or construction of per-
     sonal property for purposes of section 954(d)(1).

(Hereinafter, we shall refer to the standards of section 1.954-

3(a)(4)(iii), Income Tax Regs., that the operations conducted be

substantial in nature and be generally considered to constitute

the manufacture of a product as the facts and circumstances test

of that regulation, and we shall refer to the standard of section

1.954-3(a)(4)(iii), Income Tax Regs., that the conversion costs

be equal to 20 percent of the total cost of goods sold as the me-

chanical test of that regulation.)

     Respondent determined that the income for each of the years

at issue from the sale of sunglasses assembled by B&L Ireland and
                              - 60 -


by B&L Hong Kong constitutes foreign base company sales income as

defined in section 954(d)(1) that is includible in petitioners'

gross income under section 951(a)(1).   Petitioners argue that

that income is not foreign base company sales income as defined

in that section because the sunglasses assembled by B&L Ireland

and by B&L Hong Kong were manufactured by those companies within

the meaning of section 954(d)(1) and section 1.954-3(a)(4)(ii)

and (iii), Income Tax Regs.   Petitioners bear the burden of proof

on that issue.   Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933).   We need not address petitioners' contention that the

sunglass assembly operations of B&L Ireland and of B&L Hong Kong

satisfy section 1.954-3(a)(4)(ii), Income Tax Regs.   This is

because we find that those operations satisfy the facts and

circumstances test of section 1.954-3(a)(4)(iii), Income Tax

Regs.   See sec. 1.954-3(a)(4)(i), Income Tax Regs.

     Before turning to the application of the facts and circum-

stances test of section 1.954-3(a)(4)(iii), Income Tax Regs., to

the facts and circumstances established by the record in these

cases, we summarize our views of the experts on whom the parties

rely to support their respective positions (experts) as to

whether the sunglass assembly operations conducted by B&L Ireland

and by B&L Hong Kong constitute the manufacture of sunglasses

under section 954(d)(1) and the regulations thereunder.
                              - 61 -


The Experts

     Each of the experts prepared an opening report and a rebut-

tal report, except respondent's expert Joel S. Cohen, Ph.D. (Dr.

Cohen) who prepared only an opening report and petitioners'

expert Irving H. Plotkin, Ph.D. (Dr. Plotkin) who prepared only a

rebuttal report.   Certain of those experts provided additional

testimony at trial.

     We evaluate the opinions of experts in light of the quali-

fications of each expert and all other evidence in the record.

Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th Cir.

1973), affg. 54 T.C. 493 (1970); IT&S of Iowa, Inc. v. Commis-

sioner, 97 T.C. 496, 508 (1991); Parker v. Commissioner, 86 T.C.

547, 561 (1986).   We have broad discretion to evaluate "the over-

all cogency of an expert's analysis."   Sammons v. Commis-

sioner,838 F.2d 330, 334 (9th Cir. 1988) (quoting Ebben v.

Commissioner, 783 F.2d 906, 909 (9th Cir. 1986), affg. in part

and revg. in part on another issue T.C. Memo. 1986-318.   We are

not bound by the formulae and opinions proffered by an expert,

especially when they are contrary to our own judgment.    Orth v.

Commissioner, 813 F.2d 837, 842 (7th Cir. 1987), affg. Lio v.

Commissioner, 85 T.C. 56 (1985); Silverman v. Commissioner, 538

F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-285; Estate

of Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955),
                              - 62 -


affg. T.C. Memo. 1954-139.   Instead, we may reach a decision

based on our own analysis of all the evidence in the record.

Silverman v. Commissioner, supra at 933.    The persuasiveness of

an expert's opinion depends largely upon the disclosed facts on

which it is based.   See Tripp v. Commissioner, 337 F.2d 432, 434

(7th Cir. 1964), affg. T.C. Memo. 1963-244.   While we may accept

the opinion of an expert in its entirety, Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we

may be selective in the use of any portion of such an opinion.

Parker v. Commissioner, supra at 562.   Furthermore, we may reject

the opinion of an expert witness in its entirety.   See Palmer v.

Commissioner, 523 F.2d 1308, 1310 (8th Cir. 1975), affg. 62 T.C.

684 (1974); Parker v. Commissioner, supra at 562-565.

     Petitioners rely on the opinions of Douglas E. Nieh (Mr.

Nieh) who was employed by Polaroid Corporation (Polaroid) in its

sunglass business from 1956 through 1988.   His opinions were

based on his experience in the sunglass industry.   We found Mr.

Nieh's opinions to be helpful in resolving the issues presented,

and we rely on them to the extent discussed below in making our

findings and reaching our conclusions herein.

     Although respondent does not rely on an expert from the

sunglass industry, she does rely on the opinions of Dr. Cohen, a

licensed optician and an associate professor of Ophthalmic Dis-
                               - 63 -


pensing Technology at Cuyahoga Community College.    We have found

that there are significant differences between the assembly of

prescription glasses and the assembly of noncorrective sunglas-

ses.    We did not find Dr. Cohen's opinions to be helpful in

resolving the issues in these cases, and we do not rely on them

in making our findings and reaching our conclusions herein.

       Both parties rely on the opinions of engineers.   Petitioners

rely on the opinions of Harry W. Matthews, Jr. (Mr. Matthews), an

engineer employed by Arthur D. Little's Manufacturing and Trans-

portation Industries Section, who had no experience in the sun-

glass industry.    Although Mr. Matthews concluded that B&L Ireland

and B&L Hong Kong constituted separate manufacturing entities, he

did not address whether the assembly operations of each of those

companies were generally considered to constitute the manufacture

of sunglasses.    We also question some of the facts underlying Mr.

Matthews' analysis.    For example, he concluded that the respec-

tive sunglass assembly operations of B&L Ireland and B&L Hong

Kong involved approximately 65 steps in order to assemble metals,

70 steps to assemble leathers, and an additional 95 steps to

apply leather to metal frames.33   He further concluded that the



33
   The number of steps that Mr. Matthews concluded are required
for the assembly of sunglasses does not include a number of
support operations, such as incoming inspections and quality
audits.
                              - 64 -


sunglass assembly operations of B&L Ireland involved approxi-

mately 75 steps in order to assemble plastics.   Even petitioners

do not argue that the respective assembly operations of B&L

Ireland and B&L Hong Kong involved that many steps.   We did not

find Mr. Matthews' opinions to be helpful in resolving the issues

in these cases, and we do not rely on them in making our findings

and reaching our conclusions herein.

     Respondent relies on the opinions of Michael L. Philpott,

Ph.D. (Dr. Philpott), a manufacturing engineer, who, as of the

time of the trial herein, was employed as an assistant professor

of engineering responsible for teaching classes in manufacturing.

Dr. Philpott had no experience in the sunglass industry.   His

opinions were formulated from the perspective of an engineer and

set forth certain hypertechnical views that we do not believe

Congress had in mind when it enacted section 954(d)(1) and that

we did not find helpful to our resolution of the issues herein.

By way of illustration, Dr. Philpott drew subtle distinctions

among the terms "manufacture", "manufacturer", and "manufactu-

ring".   As discussed below, we do not believe Congress had any

such distinctions in mind when it made section 954(d)(1) part of

the Code.

     To illustrate further our concerns with the opinions of

Dr.Philpott, he utilized a definition of the term "manufacturer"
                              - 65 -


that neither Congress could have intended when it enacted section

954(d)(1) nor the Treasury could have meant when it promulgated

section 1.954-3(a)(4)(iii), Income Tax Regs.   Dr. Philpott opined

during the trial of these cases that, unless a company designed a

product, it could not be considered the manufacturer of that

product if it performed only assembly, and no parts fabrication

operations.   However, he further testified that product design

was not considered part of the manufacturing process during the

early and mid-1960s when Congress enacted subpart F and the

Treasury issued the regulations thereunder.

     We also note that Dr. Philpott opined that the assembly of

automobile parts into automobiles constitutes a substantial

transformation of those parts.   That opinion contradicts the view

of the Treasury set forth in example two of section 1.954-

3(a)(4)(iii), Income Tax Regs., that the assembly of automobile

parts into automobiles does not constitute a substantial trans-

formation of those parts under section 1.954-3(a)(4)(ii), Income

Tax Regs.

     In conclusion, we did not find Dr. Philpott's opinions to be

helpful in resolving the issues presented in these cases, and we

do not rely on them in making our findings and reaching our

conclusions herein.

     Both parties rely on the opinions of experts who performed

quantitative analyses to determine whether the respective assemb-
                              - 66 -


ly operations conducted by B&L Ireland and B&L Hong Kong were

substantial in nature within the meaning of section 1.954-

3(a)(4)(iii), Income Tax Regs.34   Petitioners rely on the opin-

ions of Gary E. Holdren (Mr. Holdren), a certified public accoun-

tant (C.P.A.).   His analyses were made from an accounting per-

spective.   Respondent relies on the opinions of three employees

(viz., Scott D. Hakala, Ph.D. (Dr. Hakala), who holds a Ph.D. in

economics; Martin D. Hanan, who is a chartered financial analyst

and an accredited senior appraiser; and Ray A. Sheeler, who is a

C.P.A.) of Business Valuation Systems (BVS) who prepared an open-

ing report (BVS report) and a rebuttal report.   Although the BVS

report incorporated accounting concepts, it primarily sets forth

economic analyses of the respective assembly operations of B&L

Ireland and B&L Hong Kong.

     The respective opinions of Mr. Holdren and the authors of

the BVS report appear to require different conclusions with

respect to the substantiality of the respective assembly opera-

tions conducted by B&L Ireland and B&L Hong Kong.   It appears

that at least part of the differences in those opinions is at-


34
   Some of the quantitative analyses performed by those experts
related to whether the respective assembly operations of B&L
Ireland and B&L Hong Kong satisfy the mechanical test of sec.
1.954-3(a)(4)(iii), Income Tax Regs. We rely on the facts and
circumstances test of that regulation in holding for petitioners
herein. Consequently, we need not, and do not, consider applica-
tion of the mechanical test of sec. 1.954-3(a)(4)(iii), Income
Tax Regs., to these cases.
                               - 67 -


tributable to the fact that Mr. Holdren's analyses were based on

accounting principles and the analyses in the BVS report were

based primarily on economic principles.    Both accounting and

economic analyses seem to be reasonable and appropriate methods

of analysis for purposes of section 954(d)(1).    Compare sec.

1.954-3(a)(4)(iii), Income Tax Regs., with S. Rept. 1881, supra,

1962-3 C.B. 703, 790.

      Nonetheless, we have reservations regarding the respective

analyses performed by Mr. Holdren and the three individuals who

prepared the BVS report.    For example, with respect to Mr.

Holdren, he adopted the classifications that B&L Ireland and B&L

Hong Kong used to classify certain purchased parts as either

direct or indirect materials, rather than making his own indepen-

dent determinations of such classifications.    Although the clas-

sifications used by B&L Ireland and by B&L Hong Kong are not

necessarily inappropriate for management accounting purposes,

there appear to be different, acceptable methods of classifying

certain types of materials for those purposes.    Petitioners have

not convinced us that the classification method chosen by B&L

Ireland and by B&L Hong Kong, and adopted by Mr. Holdren, is the

most appropriate method for purposes of section 954(d)(1) and the

regulations thereunder.35


35
     We also note that Mr. Holdren admitted at trial that he made
                                                     (continued...)
                              - 68 -


     With respect to the three individuals who prepared the BVS

report, in making the analyses reflected therein, they assumed

that the prices that B&L Ireland and B&L Hong Kong paid to B&L

Inc. and that B&L Ireland paid to B&L GmbH for sunglass parts

were not arm's length and that those prices should be estimated

based upon the fair rates of return for the assets used in the

sunglass assembly operations conducted by each of those

companies.   However, reports prepared by respondent's economist

and her examining agent for purposes of determining whether

transfer pricing adjustments should be made for petitioners'

taxable years ended December 29, 1985, through December 27, 1987,

state that the transfer prices paid by B&L Ireland and by B&L

Hong Kong for sunglass parts, which were the same transfer prices

that the parties agreed to use for petitioners' taxable years

ended December 25, 1983, and December 30, 1984, were appropriate

and that no transfer pricing adjustments were necessary.36

     The parties have not persuaded us of the reliability and

accuracy of the respective opinions of Mr. Holdren and the three

individuals who prepared the BVS report for purposes of applying



35
 (...continued)
an error in the analyses contained in his opening report.
36
   We also note that the individuals who prepared the BVS report
admitted that the data that they used in making their analyses
were incomplete and inconsistent, especially with respect to B&L
Ireland.
                              - 69 -


section 954(d)(1) and the regulations thereunder.   Except as

stated below, we did not find those opinions to be helpful in

resolving the issues in these cases.   We did not find it neces-

sary or appropriate to rely on questionable, quantitative

analyses of the respective assembly operations conducted by B&L

Ireland and B&L Hong Kong in order to resolve whether those

operations satisfy the facts and circumstances test of section

1.954-3(a)(4)(iii), Income Tax Regs.   Except as noted below, we

do not rely on the opinions of either Mr. Holdren or the three

individuals who prepared the BVS report in making our findings

and reaching our conclusions herein.

     To rebut the respective opinions expressed by Dr. Philpott

and the three individuals who prepared the BVS report, petition-

ers rely on the opinion of Dr. Plotkin, an economist employed by

Arthur D. Little, Inc.   While we found that Dr. Plotkin effec-

tively rebutted those opinions, we generally do not rely on his

opinions because they were provided to rebut the opinions of

experts upon whom we generally do not rely.

     All of the experts who prepared opening reports, except Dr.

Cohen, prepared rebuttal reports expressing opinions intended to

refute the opinions expressed in the opening reports of one or

more of the experts relied upon by the other party.   Except for

Mr. Nieh's rebuttal of Dr. Cohen that we found to be helpful in

explaining the differences between the assembly of sunglasses and
                               - 70 -


the assembly of prescription eyeglasses, we generally do not rely

upon those rebuttal reports.

Judicial Interpretations of Relevant Regulations

     In Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C.

338 (1972), petitioner Dave Fischbein Manufacturing Company

(DFMC) manufactured the parts for portable bag-closing machines37

and assembled those parts into portable bag-closing machines.     It

also sold some of the parts it manufactured to its wholly owned

subsidiary, Compagnie Fischbein, S.A. (CFSA), a Belgian corpora-

tion.   CFSA, in turn, assembled those parts into bag-closing

machines.   CFSA did not maintain a sales force, did not design

its own products, and purchased most of the parts used in assem-

bling the bag-closing machines from DFMC.38   Dave Fischbein Manu-

facturing Co. v. Commissioner, supra at 350-351.

     Relying on section 1.954-3(a)(4)(iii), Income Tax Regs., we

found on the facts presented in the Dave Fischbein Manufacturing

Co. case that the income generated by CFSA from the sale of the

portable bag-closing machines it assembled did not constitute



37
   A bag-closing machine is a type of sewing machine used to
close the mouth of an open bag for products such as animal feed,
seed, fertilizer, and processed food. Dave Fischbein Manufactur-
ing Co. v. Commissioner, 59 T.C. 338, 340 (1972).
38
   CFSA also purchased from unrelated suppliers some of the
standard parts used in portable bag-closing machines, such as
screws, nuts, and switches. Dave Fischbein Manufacturing Co. v.
Commissioner, supra at 350.
                               - 71 -


foreign base company sales income as defined in section 954(d)(1)

because the assembly operations conducted by CFSA were substan-

tial in nature and were generally considered to constitute the

manufacture of property within the meaning of that regulation.

Id. at 359.   The facts on which we relied in reaching those

conclusions included the following:

     CFSA (a) tailors and finishes some of its purchased
     components in order to place these parts in usable
     condition; (b) puts these tailored components and
     others together in a 6-hour, 58-step process to form
     salable, quality bag-closing machines; and (c) posses-
     ses in its plant all of the tools and equipment neces-
     sary for these activities. As a result of CFSA's
     operations, the purchaser of one of these devices is
     guaranteed a carefully put together, well tested, and
     operable machine.

               *     *     *     *      *    *      *

     It was the caliber of CFSA's mechanics which resulted
     in a smooth-running operation rather than a lack of
     complexity of the operations. [Id. at 360.]

     Except for Dave Fischbein Manufacturing Co. v. Commissioner,

supra, no court has had occasion to consider and apply the facts

and circumstances test of section 1.954-3(a)(4)(iii), Income Tax

Regs.   However, on two separate occasions, we considered and

applied certain language in section 1.993-3(c)(2)(iii), Income

Tax Regs., that is similar to the language prescribing the facts

and circumstances test of section 1.954-3(a)(4)(iii), Income Tax

Regs.   Garnac Grain Co. v. Commissioner, 95 T.C. 7 (1990); Webb

Export Corp. v. Commissioner, 91 T.C. 131 (1988).
                                 - 72 -


       Section 1.993-3(c)(2)(iii), Income Tax Regs., is designed to

determine whether a corporation is engaged in the manufacture or

production of a product in the United States for purposes of

section 993, one of the provisions applicable to a domestic

international sales corporation (DISC).     That regulation pro-

vides:

            (iii) Operations generally considered to consti-
       tute manufacturing. Property is manufactured or pro-
       duced by a person if the operations performed by such
       person in connection with such property are substantial
       in nature and are generally considered to constitute
       the manufacture or production of property.

"Assembly or packing operations" are not operations generally

considered to constitute the manufacture of property under sec-

tion 1.993-3(c)(2)(iii), Income Tax Regs.     See sec. 1.993-

3(c)(2)(i), Income Tax Regs.     Nonetheless, judicial interpreta-

tions of language in section 1.993-3(c)(2)(iii), Income Tax

Regs., provide useful guidelines for interpreting the same lan-

guage in section 1.954-3(a)(4)(iii), Income Tax Regs.     Cf. Webb

Export Corp. v. Commissioner, supra at 142-143.

       In the first case in which we considered and applied section

1.993-3(c)(2)(iii), Income Tax Regs., the Webb Export Corp. case,

the taxpayer purchased standing timber and harvested that timber

through a series of operations including felling, delimbing,

bucking, skidding, loading, and hauling the timber.      Id. at 133-

134.     We found therein:   "These various steps, a time-consuming,
                              - 73 -


yet time-constrained, process in which petitioner possessed all

the necessary tools and equipment utilized in its logging opera-

tions, when combined, constitute a process substantial in na-

ture."   Id. at 144.   We further found that the taxpayer's opera-

tions were generally considered to constitute production.   We

based that finding by considering, inter alia, "how harvesting or

logging is generally perceived in the forest products industry".

Id. at 148.   In that regard, we found, inter alia, that:

     (1) Loggers consider themselves to be producers;
     (2) standing timber is not particularly useful to
     manufacturers; (3) substantial activities are required
     before such materials are useful to manufacturers; and
     (4) the items considered to be raw materials and who is
     perceived to be a producer, varies depending upon one's
     position in the manufacturing and/or production pro-
     cess. [Id.]

     We again considered the meaning of and applied section

1.993-3(c)(2)(iii), Income Tax Regs., in Garnac Grain Co. v.

Commissioner, supra.   There, the taxpayer purchased grain that it

stored in its grain elevators, processed that grain in a series

of operations including drying, cleaning, aerating, blending, and

fumigating, and sold it for export purposes.   We found that the

taxpayers' operations were substantial in nature because they

required "trained and experienced personnel employing both skill

and judgment in the performance of their duties."   Id. at 28.

However, relying primarily on the fact that the grain industry

considered the taxpayers' operations to constitute grain handling
                               - 74 -


or grain merchandising, rather than the production or manufacture

of a product, we further found that the taxpayers' operations

were not generally considered to constitute the manufacture or

production of grain within the meaning of section 1.993-

3(c)(2)(iii), Income Tax Regs.     Id. at 23-32.

Application of the Facts and Circumstances Test of Section
1.954-3(a)(4)(iii), Income Tax Regs., to the Present Cases

     Were the Assembly Operations At Issue
     Substantial in Nature?

     Petitioners contend that the respective assembly operations

conducted by B&L Ireland and B&L Hong Kong were substantial in

nature.    Respondent disagrees.

     To determine whether the respective sunglass assembly opera-

tions conducted by B&L Ireland and B&L Hong Kong were substantial

in nature, we must examine the facts and circumstances surround-

ing those operations.    Sec. 1.954-3(a)(4)(iii), Income Tax Regs.

Respondent contends that those assembly operations were so simple

that they did not require sufficient skill and judgment to rise

to the level of being substantial in nature.       We disagree.

     We have found that operators at both B&L Ireland and B&L

Hong Kong required training and experience in sunglass assembly

techniques before they became proficient at assembling sun-

glasses.    At the B&L Ireland sunglass assembly facility, the

training period for each new operator, which included one-on-one

supervision by a full-time instructor, lasted 13 weeks.       At the
                              - 75 -


B&L Hong Kong sunglass assembly facility, new operators also

received extensive training supervised by the assistant produc-

tion supervisor and group leaders.

     During the first few weeks of training, the percentage of

salable sunglasses assembled by a new operator at both B&L

Ireland and B&L Hong Kong was very low.   Even at the end of the

13-week training program at the B&L Ireland sunglass assembly

facility, the typical operator was able to assemble only 70 per-

cent of B&L Ireland's basic target of 200 sunglasses per day.

Although the typical operator at the B&L Hong Kong sunglass

assembly facility was able to achieve the basic daily produc-

tivity target of 150 sunglasses per day within four to six weeks

after the commencement of the training program, that person

generally was not able to achieve B&L Hong Kong's average output

of 380 sunglasses per day until some time in that person's second

year of employment.   Not all operators were able to assemble all

SKUs of sunglasses assembled by B&L Ireland and by B&L Hong Kong,

and some operators were not able to reach a sufficient level of

proficiency to continue to function as operators.   At the B&L

Ireland sunglass assembly facility, if an operator began assem-

bling a new style of sunglasses or switched from assembling plas-

tics to metals, the operator underwent additional training.

     In addition to the training provided to operators, both B&L

Ireland and B&L Hong Kong provided extensive training to inspec-
                              - 76 -


tors, even if those persons had been operators prior to becoming

inspectors.

     B&L Ireland's experiences in establishing its sunglass

assembly operations illustrate the need for trained and exper-

ienced personnel (including operators, inspectors, and manage-

ment) to assemble quality sunglasses.   When it first began assem-

bling sunglasses during 1982 and 1983, B&L Ireland experienced a

rejection rate of approximately 80 percent of the sunglasses

assembled by its operators.   To improve the quality of its prod-

uct, B&L Ireland's sunglass operations (1) instituted its own

training program, including hiring full-time instructors begin-

ning in May 1983; (2) underwent a quality audit performed during

1984 by the quality manager of B&L Ireland's contact lens opera-

tions in order to develop standard operating procedures; (3) re-

placed its quality assurance manager shortly after concluding the

quality audit; (4) reduced its expected output in its production

budget for its second year of operation (viz., 1984); and

(5) hired outside consultants during 1983 and 1984 to develop a

job evaluation system and improve the efficiencies of its opera-

tions.   Most quality problems at the B&L Ireland sunglass assemb-

ly facility with respect to the basic SKUs tended to disappear

over time as the operators and management became more skillful in

their respective functions and responsibilities in the sunglass
                              - 77 -


assembly operations.39

      B&L Ireland and B&L Hong Kong relied upon their respective

operators to perform their functions and responsibilities proper-

ly.   If those operators had failed to perform them properly, the

sunglasses assembled by those companies would not have met B&L's

quality standards or the appearance and fit expectations of the

ultimate consumers of quality sunglasses.   While some operator

errors, such as failure to make an appropriate adjustment during

the truing process or failure to correct a lens gap problem, were

able to be fixed through reworking the sunglasses, many operator

errors, such as chipped lenses or broken solder on the endpieces,

required the damaged parts to be scrapped and replaced.   As the

operators at B&L Ireland and B&L Hong Kong became more experi-

enced at assembling particular SKUs, the operators became skilled

at reducing damage to the parts and meeting B&L's specifications

for quality.   They tended to learn, for example, (1) how much

pressure to apply to a part in order to bend it without breaking

or otherwise damaging it; (2) how much to adjust the speed and

temperature controls on the heating tunnel in order to make the

plastic fronts sufficiently malleable to insert lenses without

overheating the fronts; (3) how to recognize and correct lens gap



39
   B&L Hong Kong also undertook certain actions to improve the
quality problems it suffered during the first year (viz., 1983)
of its sunglass assembly operations.
                              - 78 -


problems; and (4) how to overcome problems caused by tolerance

stacking.

     To support her position that the respective sunglass assem-

bly operations conducted by B&L Ireland and B&L Hong Kong did not

require substantial skill, training, or experience, respondent

relies on the testimony of Dr. Cohen.   At the time of the trial

herein, Dr. Cohen was a licensed optician and an associate pro-

fessor of Ophthalmic Dispensing Technology.    Dr. Cohen testified

that he had taught basic assembly of prescription eyeglasses to

students of various levels of education and that it did not

require much time or training for a person to become competent at

assembling eyeglasses.   Dr. Cohen admitted, however, that his

experience related to the dispensing of prescription eyeglasses

through optical shops and that it did not include mass production

techniques.

     We are unwilling to rely on Dr. Cohen's testimony to refute

the direct evidence of the training and experience required of

operators at B&L Ireland and B&L Hong Kong in order to assemble

sunglasses that met B&L's quality standards.   It appears that a

person assembling prescription eyeglasses for a retail optical

shop is not required to learn a standard technique for that

assembly.   All that is important is the end result, not the

method utilized to achieve that result.   For example, Dr. Cohen

testified that when students in the Cleveland Job Corps, a
                              - 79 -


program in which Dr. Cohen trained nontraditional students in

Ophthalmic Dispensing Technology, including prescription eyeglass

assembly, were learning how to insert lenses into metal frames,

they were given study guides that outlined the materials to be

used and the basic tasks to be performed, and they were allowed

to perform those tasks at their own pace.    Dr. Cohen did not

provide instruction in assembly techniques unless a student was

having difficulty completing the assembly.

     While such result-oriented instruction may have been accept-

able in a setting such as the Cleveland Job Corps where the

participants were expected to assemble an optimum of 15 to 20

pairs of eyeglasses per week, B&L Ireland and B&L Hong Kong

trained their respective employees to use a standard technique

for sunglass assembly that the operators could repeat several

hundred times per day efficiently and correctly so as to result

in consistently producing quality sunglasses.    Unlike prescrip-

tion eyeglasses that are assembled to fit a particular face and

for a specific prescription, sunglasses must be assembled to fit

a standard face.   Consequently, there is a greater need for

consistent results with respect to the assembly of sunglasses

than with respect to the assembly of prescription eyeglasses.

The use of a standard technique for sunglass assembly allowed

operators at B&L Ireland and at B&L Hong Kong to achieve maximum

output of finished sunglasses that met B&L's quality standards
                              - 80 -


with the least damage to the parts occurring during the process.

See Webb Export Corp. v. Commissioner, 91 T.C. at 143.     The

record in these cases shows that it took significant periods of

training and experience for operators to learn the standardized

techniques utilized by B&L Ireland and by B&L Hong Kong to as-

semble sunglasses ready for sale to the ultimate consumers.      Even

Dr. Cohen admitted that certain problems encountered by B&L

Ireland and by B&L Hong Kong might have been attributable to the

fact that they were mass producing sunglasses, rather than assem-

bling prescription eyeglasses for a retail optical shop.

      In addition, the sunglasses assembled at both B&L Ireland

and B&L Hong Kong were inspected at least once by someone other

than the operator who assembled them to ensure that the sunglas-

ses complied with B&L's quality standards.   Dr. Cohen testified

that, at least in Ohio, an optician was required to examine

prescription eyeglasses before they were distributed to the

ultimate consumer.   Although the position of an inspector at B&L

Ireland and at B&L Hong Kong was not the equivalent of an

optician who is licensed and trained to dispense prescription

eyeglasses, the record in these cases establishes that inspectors

at B&L Ireland and at B&L Hong Kong required significant periods

of training and experience in order to perform their jobs proper-

ly.   The need for trained inspectors to ensure that the sun-

glasses assembled by B&L Ireland and by B&L Hong Kong met B&L's
                               - 81 -


quality standards further demonstrates the substantiality of the

assembly operations conducted by each of those corporations.

     Respondent also contends that the assembly operations at

issue did not require a sufficient investment in physical capital

to be substantial in nature.   Although we agree with respondent

that the respective sunglass assembly operations conducted by B&L

Ireland and B&L Hong Kong did not require a large investment in

physical capital, her contention ignores the fact that those

operations required a substantial investment in human capital in

order to produce quality sunglasses.    Without a trained and

experienced workforce, neither B&L Ireland nor B&L Hong Kong

would have been able to produce quality sunglasses that met B&L's

quality standards.   In fact, both B&L Ireland and B&L Hong Kong

experienced significant quality problems during their respective

first years of operation.   Those operations could not readily be

relocated since they were dependent on a trained and experienced

workforce.   In fact, the IDA considered B&L Ireland's sunglass

assembly operations to create jobs of a sufficiently permanent

nature to warrant the issuance of training grants to compensate

B&L Ireland for the period during which its employees were not

efficient at producing quality sunglasses.

     Respondent further contends that the actual assembly of

sunglasses by B&L Ireland and by B&L Hong Kong did not require

substantial amounts of time to accomplish and therefore cannot be
                              - 82 -


substantial in nature under the facts and circumstances test

prescribed in section 1.954-3(a)(4)(iii), Income Tax Regs.40     We

disagree.   Nothing in that test suggests that operations that do

not require substantial amounts of time to complete can never be

substantial in nature.   To the contrary, all of the facts and

circumstances surrounding the operations at issue must be ex-

amined under that test in order to determine whether those opera-

tions are substantial in nature.   See sec. 1.954-3(a)(4)(iii),

Income Tax Regs.

     Moreover, respondent's contention that the actual assembly

of sunglasses by B&L Ireland and by B&L Hong Kong did not require

substantial amounts of time and therefore cannot be substantial

in nature ignores the range of the sunglass assembly operations

conducted by each of those corporations.   Both B&L Ireland and

B&L Hong Kong performed the full range of activities necessary to

assemble sunglass parts into finished, quality sunglasses.     Both


40
   Records from B&L Hong Kong for the years at issue show that
the actual "Time for 1 unit assembled" ranged from a high of
approximately two minutes during 1983 to a low of approximately
one minute during 1987. Although no such records exist for B&L
Ireland, Dr. Philpott, a manufacturing engineer and expert relied
upon by respondent, estimated the time for assembly for (1)
metals at 1.77 minutes, (2) plastics at 1.84 minutes, and (3)
leathers (including applying the leather to the frames) at 4.06
minutes. Dr. Philpott made his estimates of the time required
for assembly of the various styles of sunglasses using a design
for assembly (DFA) analysis. DFA analysis utilizes a database of
time required to perform certain assembly-related tasks in order
to aid engineers in designing products in such a way that they
can be assembled most efficiently.
                              - 83 -


companies (1) leased production facilities to assemble sunglasses

and warehouses to store finished goods; (2) employed management

teams to prepare production plans and order parts from their

suppliers; (3) hired and trained the necessary personnel to carry

out their operations; (4) inspected purchased parts for defects

and prepared those parts for assembly; (5) assembled sunglass

parts into finished sunglasses; (6) inspected finished sunglasses

for cosmetic and functional defects; and (7) cleaned and packaged

sunglasses to prepare them for distribution.   All of those ac-

tivities were necessary and essential to the assembly by B&L

Ireland and by B&L Hong Kong of the purchased sunglass parts into

finished, quality sunglasses that met B&L's quality standards and

that were ready for sale to the ultimate consumers.

     Respondent also argues that the respective assembly opera-

tions conducted by B&L Ireland and B&L Hong Kong were not sub-

stantial in nature when compared to the fabrication of the parts

used in those operations.   Respondent's argument misses the mark.

Section 1.954-3(a)(4)(iii), Income Tax Regs., requires a deter-

mination of whether "the operations conducted by the selling

corporation in connection with the property purchased and sold

are substantial in nature".   Under those regulations, we examine

the distinct operations conducted by the CFC with respect to the

purchased property to determine if those operations, standing

alone and without regard to the operations conducted by the
                               - 84 -


related party who sold the property to the CFC, are substantial

in nature.

     Based on our examination of the entire record before us, we

find that the sunglass assembly operations conducted by B&L

Ireland and by B&L Hong Kong with respect to the parts they

purchased from related parties were substantial in nature within

the meaning of section 1.954-3(a)(4)(iii), Income Tax Regs.

     Were the Assembly Operations at Issue Generally
     Considered to Constitute the Manufacture of Sunglasses?

     Petitioners contend that the respective sunglass assembly

operations conducted by B&L Ireland and B&L Hong Kong were gen-

erally considered to constitute the manufacture of sunglasses.

Respondent disagrees.

     The determination of whether the assembly operations of a

company are generally considered to constitute the manufacture of

a product is based on the facts and circumstances surrounding

those operations.   Sec. 1.954-3(a)(4)(iii), Income Tax Regs.   The

most important factor in making that determination is whether the

industry in which the company is involved generally considers

those operations to constitute the manufacture or production of

property.    See Garnac Grain Co. v. Commissioner, 95 T.C. at 29;

Webb Export Corp. v. Commissioner, 91 T.C. at 148.

     Petitioners argue that we should look to the sunglass in-

dustry to determine whether it generally considers the respective
                              - 85 -


sunglass assembly operations conducted by B&L Ireland and B&L

Hong Kong to constitute the manufacture of sunglasses.    Respon-

dent expresses no position as to whether we should look to that

or any other industry to determine whether those operations

constitute the manufacture of sunglasses.   We take respondent's

silence to mean that she agrees with petitioners' position that

the pertinent industry is the sunglass industry.

     In any event, we agree with petitioners' position.     See

Garnac Grain Co. v. Commissioner, supra at 26-27; Webb Export

Corp. v. Commissioner, supra at 148.    The products at issue

herein are sunglasses.   Sunglasses involve at least two distinct

market segments:   (1) Low-end or regular sunglasses, and

(2) high-end or quality sunglasses.    Sunglasses constitute a

separate and distinct product from prescription eyeglasses.

Sunglasses have noncorrective lenses, are tailored to fit a

standard face, and are assembled prior to reaching the retailer.

In contrast, prescription eyeglasses contain individually finish-

ed lenses, are tailored for a specific prescription and to fit an

individual face, and are assembled by retail optical shops.       We

also note that the sunglass industry has its own trade organiza-

tion, viz., the Sunglass Association of America (SAA), and that

the American National Standards Institute (ANSI) has established

standards for the sunglass industry to follow.

     Our next inquiry is whether the sunglass industry generally
                              - 86 -


considers the respective assembly operations of B&L Ireland and

B&L Hong Kong to constitute the manufacture or production of sun-

glasses.   In this respect, we find the opinions expressed by

petitioners' expert Mr. Nieh to be most instructive.     Mr. Nieh

was employed by Polaroid in its sunglass business from 1956

through 1988.   In addition to his participating in Polaroid's

sunglass business, Mr. Nieh participated in, and served as the

president of, the SAA and served on committees of ANSI in areas

relating to sunglass standards.

     In his opening report, Mr. Nieh discussed the sunglass in-

dustry in general, including the differences between low-end or

regular sunglasses and high-end or quality sunglasses.   He

described the importance of "appearance" and "fit" to the con-

sumer of quality sunglasses; that is to say, a consumer will not

purchase a pair of quality sunglasses that are priced two-to-ten

times higher than regular sunglasses unless they meet his or her

standards for appearance and fit.   He described the sunglass

industry as a "cottage industry" because several levels of manu-

facturing, including parts fabrication and final assembly, are

necessary to convert raw materials into finished sunglasses.     Al-

though Mr. Nieh recognized the importance of each level of manu-

facturing, he indicated that the sunglass industry considers the

assembler, which he referred to as the finished goods manufac-

turer, as the most important stage in the manufacture of quality
                               - 87 -


sunglasses.    This is because the assembler "must produce the

acceptable and marketable sunglass product."    Mr. Nieh noted that

sunglass parts are not sold to ultimate consumers.    He also

detailed the reliance of the assembler of quality sunglasses on a

trained and experienced work force and the quality procedures

that must be utilized by that assembler to ensure that the sun-

glasses produced meet the consumers' standards for appearance and

fit.    Based on his experience in the sunglass industry, Mr. Nieh

concluded that B&L Ireland and B&L Hong Kong conducted "manu-

facturing operations" and that "the sunglass industry would

certainly recognize B&L Ireland and B&L Hong Kong as engaged in

the manufacture and sale of 'quality sunglasses.'"

       In addition to the testimony of Mr. Nieh, we also rely on

the testimony of Mr. Davis who testified as a fact, and not an

expert, witness.    From 1963 through the early 1980s, Mr. Davis

was an employee of Polaroid U.K., which marketed and distributed

sunglasses in the United Kingdom.    At the time he joined Polaroid

U.K., it sold sunglasses that were assembled for it by Polarizer

U.K., an unrelated company, from lenses that Polaroid U.K. im-

ported from the United States and from frames purchased by

Polaroid U.K.    After joining Polaroid U.K., Mr. Davis, acting as

a representative of that company, became the production manager

of the assembly operations conducted by Polarizer U.K.    His work

included improving the quality control of the vendors supplying
                              - 88 -


frames and training the Polarizer U.K. staff in quality control

procedures.

     The assembly operations conducted by Polaroid U.K. and

Polarizer U.K. throughout the period during which Mr. Davis was

production manager were very similar to the assembly operations

conducted by B&L Ireland and by B&L Hong Kong.   Parts were pur-

chased, sorted, and inspected.   The parts were assembled into

finished sunglasses with each operator responsible for quality

control.   The finished sunglasses underwent a final inspection

before they were shipped.

     Mr. Davis testified that the factory in which he worked was

a "manufacturing unit" and that he was classified as a "manu-

facturing manager".   He also referred to the work of Polarizer

U.K. as "production" and indicated that customer returns were due

to "production problems".   Thus, it appears that Polaroid U.K.

generally considered the assembly operations conducted by

Polarizer U.K., which were very similar to the sunglass assembly

operations conducted by B&L Ireland and by B&L Hong Kong, to

constitute the manufacture of sunglasses.

     In addition, although we assume that most, if not all, of

B&L's current and former employees who testified in these cases

were prepared by counsel before trial, and we recognize that

their testimony served B&L's interests, we note that those wit-

nesses generally referred to the assembly operations of B&L
                              - 89 -


Ireland and B&L Hong Kong as manufacturing or production.   See

Webb Export Corp. v. Commissioner, 91 T.C at 148.    For example,

Peter McNally, who was the production manager of B&L Ireland's

sunglass assembly operations, testified:    "The sunglass operation

[conducted by B&L Ireland] is generally known as the Sunglass

Manufacturing Plant because it was the center for the manufactur-

ing of sunglasses for the European and Middle Eastern market."

     Petitioners also argue that the respective assembly opera-

tions conducted by B&L Ireland and B&L Hong Kong were generally

considered to constitute the manufacture of sunglasses from

various other perspectives.   Both B&L Ireland and B&L Hong Kong

used standard cost accounting to assist their management.   Mr.

Holdren, a C.P.A. relied upon by petitioners as an expert wit-

ness, concluded that the type and complexity of the respective

cost accounting systems utilized by B&L Ireland and B&L Hong Kong

are indicative of manufacturing companies and not distribution

operations.   Thus, both B&L Ireland and B&L Hong Kong used the

types of accounting systems utilized by companies engaged in the

manufacture of products.

     We also note that the Government of Ireland generally con-

sidered the assembly operations conducted by B&L Ireland to

constitute the manufacture of sunglasses.   Prior to the time

during 1982 at which B&L Ireland initiated it sunglass assembly

operations, the IDA awarded B&L Ireland both capital and training
                              - 90 -


grants that were generally given only to manufacturing concerns

that exported products from Ireland.   Moreover, pursuant to an

exemption that was generally available only with respect to goods

manufactured in Ireland, B&L Ireland was relieved of its obliga-

tion to pay Ireland's corporation tax with respect to practically

all, if not all, of its income from its sunglass assembly opera-

tions.   Nor was B&L Ireland required to pay Ireland's VAT on the

sunglass parts it imported into Ireland.   This was because the

regulations under the VAT provided an exemption for firms engaged

in a manufacturing business that were importing goods for use in

that business.

     Although we do not place determinative weight on the defini-

tion of manufacturing used by other governments, that the Govern-

ment of Ireland generally considered the assembly operations of

B&L Ireland to constitute the manufacture of sunglasses is con-

sistent with other evidence herein on which we rely supporting a

finding that those operations, as well as the assembly operations

of B&L Hong Kong, were generally considered to constitute the

manufacture of sunglasses for purposes of section 954(d)(1) and

section 1.954-3(a)(4)(iii), Income Tax Regs.

     On brief, respondent concedes that the respective assembly

operations conducted by B&L Ireland and B&L Hong Kong were manu-

facturing operations.   Even her expert, Dr. Philpott, stated that

"the processes and operations used [by B&L Ireland and by B&L
                              - 91 -


Hong Kong] would be considered 'manufacturing' in the broadest

engineering sense".   Nonetheless, Dr. Philpott testified, and

respondent argues, that even though those operations were part of

the manufacturing process, they do not by themselves constitute

the manufacture of sunglasses.

     The analyses of respondent and her expert Dr. Philpott are

based on their belief that there is a distinction between a

company that is engaged in manufacturing and one that manufac-

tures a product or is considered a manufacturer of a product.

While any distinctions among the terms "manufacturing",

"manufacturer", and "manufacture" may be important to an engineer

like Dr. Philpott, we do not find any such distinctions to be

important to our determination of whether the respective sunglass

assembly operations of B&L Ireland and B&L Hong Kong were

generally considered to constitute the manufacture of sunglasses

for purposes of section 954(d)(1) and section 1.954-3(a)(4)(iii),

Income Tax Regs.   In fact, the legislative history of subpart F

uses all three words interchangeably.   See S. Rept. 1881, supra,

1962-3 C.B. 703, 790, 949.   We do not believe that Congress in

enacting section 954(d)(1) or the Treasury in promulgating

section 1.954-3(a)(4)(iii), Income Tax Regs., intended to draw

such technical engineering distinctions among those three words.

We rely, inter alia, on the admissions by respondent and her

expert that the respective sunglass assembly operations conducted
                                - 92 -


by B&L Ireland and B&L Hong Kong were generally considered manu-

facturing in determining whether those operations were generally

considered to constitute the manufacture of sunglasses.

     Based on our examination of the entire record before us, we

find that the sunglass assembly operations conducted by B&L

Ireland and by B&L Hong Kong with respect to the sunglass parts

purchased by those companies were generally considered to consti-

tute the manufacture or production of sunglasses for purposes of

section 954(d)(1) and section 1.954-3(a)(4)(iii), Income Tax

Regs.

     Were the Assembly Operations at
     Issue Limited to Minor Assembly?

        Respondent directs the Court's attention to the third

sentence of section 1.954-3(a)(4)(iii), Income Tax Regs.     That

sentence provides:     "In no event, however, will packaging, re-

packaging, labeling, or minor assembly operations constitute the

manufacture, production, or construction of property for purposes

of section 954(d)(1)."     Based on that sentence, respondent con-

tends, inter alia, that even if the sunglass assembly operations

conducted by B&L Ireland and by B&L Hong Kong were substantial in

nature and were generally considered to constitute the manufac-

ture of sunglasses so that such operations satisfied the facts

and the circumstances test of section 1.954-3(a)(4)(iii), Income

Tax Regs., those operations were limited to "packaging, repackag-
                              - 93 -


ing, labeling, or minor assembly" and therefore cannot constitute

the manufacture of sunglasses for purposes of section 954(d)(1).

Petitioners counter, inter alia, that the assembly operations

conducted by B&L Ireland and by B&L Hong Kong were not limited to

packaging, repackaging, labeling, or minor assembly because those

operations were substantial in nature and were generally

considered to constitute the manufacture of sunglasses.

     We have serious reservations about respondent's argument

that the third sentence of section 1.954-3(a)(4)(iii), Income Tax

Regs., modifies the facts and circumstances test of that regula-

tion.   We fail to see how an operation can satisfy that test

(i.e., be substantial in nature and be generally considered to

constitute the manufacture of a product) if it is limited to

packaging, repackaging, labeling, or minor assembly.

     However, we need not decide whether respondent's argument

about the third sentence of section 1.954-3(a)(4)(iii), Income

Tax Regs., is correct because even if it were, we would nonethe-

less find that the respective sunglass assembly operations con-

ducted by B&L Ireland and B&L Hong Kong were not limited to

packaging, repackaging, labeling, or minor assembly.   B&L Ireland

and B&L Hong Kong purchased sunglass parts that could not be sold

to the ultimate consumers no matter how they were packaged.

Through a series of operations, those companies assembled the

parts that they purchased into quality sunglasses ready for sale
                               - 94 -


to the ultimate consumers.    Those sunglass assembly operations

were not minor, nominal, or insignificant.    They required trained

and experienced personnel who could quickly and efficiently

assemble sunglasses that met B&L's quality standards.    In addi-

tion to the actual assembly of sunglasses, those operations also

required trained inspection personnel to detect quality problems

in both the purchased parts and the finished sunglasses and a

management staff to plan and oversee the production operation.

Although the assembly operations of B&L Ireland and B&L Hong Kong

also included labeling and packaging operations, those operations

were not limited to such "ministerial functions".    See Dave

Fischbein Manufacturing Co. v. Commissioner, 59 T.C. at 360.

     To support her position that the assembly operations con-

ducted by B&L Ireland and by B&L Hong Kong constituted minor

assembly, respondent relies on the testimony of Dr. Philpott.      In

his opening report, Dr. Philpott opined that the assembly opera-

tions of each of those companies "would be considered by an

industrial or manufacturing engineer as minor assembly, labeling,

packaging, or repackaging."    Dr. Philpott admitted, however, that

the phrase "minor assembly" is not a term commonly used by in-

dustrial or manufacturing engineers.    Rather than giving an

opinion concerning an industry standard, it appears that Dr.

Philpott gave his opinion as to the meaning of the term "minor

assembly" for purposes of section 1.954-3(a)(4)(iii), Income Tax
                              - 95 -


Regs.   That is not the role of an expert, see Marx & Co. v.

Diners' Club Inc., 550 F.2d 505, 508-511 (2d Cir. 1977); Garnac

Grain Co. v. Commissioner, 95 T.C. at 26-27, and we do not rely

on Dr. Philpott's definition of the term "minor assembly" in

making our findings and reaching our conclusions herein.

     Based on our review of the entire record before us, we find

that the assembly operations conducted by B&L Ireland and by B&L

Hong Kong were not limited to packaging, repackaging, labeling,

or minor assembly within the meaning of the third sentence of

section 1.954-3(a)(4)(iii), Income Tax Regs.

     Conclusion41

     Based on our review of the entire record in the present

cases, we find that the sunglasses assembled by B&L Ireland and

by B&L Hong Kong were manufactured in Ireland and Hong Kong,

respectively, for purposes of section 954(d)(1) and that there-

fore the income from the sale of those sunglasses for each of the

years at issue does not constitute foreign base company sales

income as defined in that section.     Accordingly, such income is

not includible in petitioners' income under section 951(a)(1).

B&L Hong Kong--Section 954(b)(4)

     In addition to arguing that the sunglass assembly operations



41
   Although we do not address herein every argument advanced by
respondent under sec. 954(d)(1), we have considered all of her
arguments and find them to be without merit.
                             - 96 -


of B&L Hong Kong constituted the manufacture of sunglasses for

purposes of section 954(d)(1) and that therefore the income from

those operations does not constitute gross income to petitioners,

petitioners further argue that, pursuant to section 954(b)(4),

the income of B&L Hong Kong is excludible from their gross income

for their taxable years ended December 25, 1983, through December

28, 1986.42

     Section 954(b)(4) provides in pertinent part:

          (4) Exception for Foreign Corporations Not Avail-
     ed of To Reduce Taxes.--For purposes of subsection (a),
     foreign base company income does not include any item
     of income received by a controlled foreign corporation
     if it is established to the satisfaction of the Secre-
     tary that neither--

               (A) the creation or organization of such
          controlled foreign corporation under the laws of
          the foreign country in which it is incorporated *
          * *, nor

               (B) the effecting of the transaction giving
          rise to such income through the controlled foreign
          corporation,

     has as one of its significant purposes a substantial
     reduction of income, war profits, or excess profits or
     similar taxes. * * *

     The exception in section 954(b)(4) applies only "if it is

established to the satisfaction of the Secretary" that the reduc-



42
   Petitioners' argument does not relate to their last taxable
year at issue (viz., the year ended Dec. 27, 1987) because sec.
954(b)(4) in effect for their taxable years ended Dec. 25, 1983,
through Dec. 28, 1986, was amended in 1986 and was no longer
effective for that last year.
                                - 97 -


tion of taxes was not a significant purpose for forming the CFC

or effecting the transactions that gave rise to the income.      R.E.

Dietz Corp. v. United States, 939 F.2d 1, 5 (2d Cir. 1991).      We

do not substitute our judgment for that of respondent; we review

respondent's judgment only to determine whether she abused her

discretion in concluding that tax avoidance was a significant

purpose.   The question whether respondent abused her discretion

is a question of fact.     Capitol Fed. Sav. & Loan v. Commissioner,

96 T.C. 204, 213 (1991).    We will not overturn respondent's

judgment unless it is shown to be arbitrary and capricious.      R.E.

Dietz Corp. v. United States, supra at 5; Capitol Fed. Sav. &

Loan v. Commissioner, supra at 213.

     For purposes of section 954(b)(4), "to be significant a

purpose must be important, but it is not necessary that it be the

principal purpose or the purpose of first importance."    Sec.

1.954-1(b)(3)(iii), Income Tax Regs.     To determine if tax reduc-

tion was a significant purpose, we must examine all of the facts

and circumstances.   Sec. 1.954-1(b)(3)(iv), Income Tax Regs.

Among the factors to be considered are the following:    (1) The

various purposes for the action, (2) the type of business carried

on, (3) the classes of income derived, (4) the frequency with

which the particular item of income is derived, (5) the effective

rate of tax imposed on the income, (6) the place in which the

income-producing transaction occurs or the source of such income,
                               - 98 -


and (7) the location of the persons purchasing the goods or

services.   Id.   Generally, if the income-producing activity of

the CFC takes place within the country in which the CFC is or-

ganized, the formation of that company will not be considered to

have a significant purpose of reducing taxes.      Id.

     Petitioners argue, and respondent does not dispute, that

during petitioners' taxable years ended December 25, 1983,

through December 28, 1986, B&L Hong Kong had income from the

following three principal sources:      (1) The sale of sunglasses

assembled by B&L Hong Kong, (2) the sale of B&L products not

assembled by B&L Hong Kong,43 and (3) interest.     It is not clear

from the record whether B&L Hong Kong had income from any other

sources during those years.   To the extent that B&L Hong Kong had

any such income that is at issue herein, petitioners have failed

to carry their burden of proving that such income is excludible

from their gross income for those years under section 954(b)(4).

     As for the three sources of B&L Hong Kong's income about

which petitioners argue under section 954(b)(4), we have held

that the income of B&L Hong Kong attributable to the sale of

sunglasses it assembled is not subpart F income for any of the

years at issue.   Therefore, we need not determine whether the

exception in section 954(b)(4) applies to that income.


43
   Petitioners do not argue that B&L Hong Kong sold any products
manufactured in Hong Kong other than the sunglasses it assembled.
                              - 99 -


     In addition, certain income of B&L Hong Kong from the sale

of B&L products it did not assemble is not at issue for petition-

ers' taxable years ended December 25, 1983, through December 28,

1986.   Specifically, the record discloses that neither the income

of B&L Hong Kong from the sale of B&L products for use or con-

sumption in Hong Kong, see sec. 954(d)(1)(B), nor its income

during petitioners' taxable year ended December 30, 1984, from

the sale of products purchased from B&L Ireland, see sec. 1.954-

1(b)(4)(iii)(a), Income Tax Regs., is at issue.   It is not clear

from the record whether any other income of B&L Hong Kong from

the sale of B&L products it did not assemble is at issue.   How-

ever, we presume that the parties will exclude any such income

that is not at issue when making their computations herein under

Rule 155.

     We now turn to the parties' arguments under section

954(b)(4) relating to B&L Hong Kong's income from the sale of B&L

products it did not assemble and from interest that the parties

and/or the record make clear is at issue.   Respondent argues that

she did not abuse her discretion under section 954(b)(4) by

failing to exclude the income at issue of B&L Hong Kong from the

sale of B&L products it did not assemble and from interest from

petitioners' gross income for their taxable years ended December

25, 1983, through December 28, 1986.   Although the record in

these cases might support a finding that B&L Hong Kong was not
                              - 100 -


formed for a significant purpose of reducing taxes, it does not

necessarily follow that respondent abused her discretion by

failing to exclude the income at issue of B&L Hong Kong from the

sale of B&L products it did not assemble and from interest from

petitioners' gross income for their taxable years ended December

25, 1983, through December 28, 1986.    In any event, the instant

record does not support a finding that respondent abused her

discretion by failing to determine that reduction of taxes was

not a significant purpose for effecting the transactions that

gave rise to that income.

     We initially note that petitioners reported certain of B&L

Hong Kong's income from sources other than the sale of sunglasses

assembled by it as subpart F income for each of their taxable

years ended December 30, 1984, through December 28, 1986.

Although petitioners did not report subpart F income from B&L

Hong Kong for their taxable year ended December 25, 1983, a

memorandum prepared by B&L in connection with the tax audit of

petitioners' taxable years ended December 25, 1983, and December

30, 1984, indicated that petitioners did not report any such

income for their taxable year ended December 25, 1983, because

B&L Hong Kong "generated an overall loss from Subpart F opera-

tions" for that year.   Petitioners did not assert that any por-

tion of B&L Hong Kong's income at issue from the sale of B&L

products it did not assemble and from interest was excludible
                               - 101 -


from their gross income under section 954(b)(4) until they filed

their amended petitions in these cases less than three months

prior to trial.    It appears that, at least prior thereto, peti-

tioners themselves had reason to believe that that income was not

excludible from their gross income under section 954(b)(4) for

their taxable years ended December 25, 1983, through December 28,

1986.

     With respect to B&L Hong Kong's interest income at issue,

petitioners do not point to any evidence to support a finding

that reducing taxes was not a significant purpose for effecting

the transactions that gave rise to that interest income.44    Al-

though petitioners argue on brief that B&L Hong Kong had interest

income from investments of its working capital, it is not clear

from the record what transactions gave rise to the interest

income at issue.   On the record before us, we find that peti-

tioners failed to prove that respondent abused her discretion by

failing to conclude that reducing taxes was not a significant

purpose for effecting the transactions that gave rise to B&L Hong




44
   On brief, respondent argues that the issue whether B&L Hong
Kong's interest income is excludible under sec. 954(b)(4) is not
a proper issue because it was not raised in the pleadings.
Respondent is wrong. Petitioners amended their petition to
assert that B&L Hong Kong's income from the sale of B&L products
it did not assemble and from "other revenues" was excludible
under sec. 954(b)(4).
                              - 102 -


Kong's interest income at issue.45

     With respect to B&L Hong Kong's income at issue from the

sale of B&L products it did not assemble, petitioners argue that

the factors set forth in section 1.954-1(b)(3)(iv), Income Tax

Regs., show that the transactions that gave rise to that income

were not effected for a significant purpose of reducing taxes.

We disagree.   We have examined all of the facts and circumstances

disclosed by the record with respect to that income and find that

petitioners have failed to show that respondent abused her dis-

cretion by failing to determine that the transactions that gave

rise to B&L Hong Kong's income at issue from the sale of B&L

products it did not assemble were not effected for a significant

purpose of reducing taxes.

     Although the testimony of current and former B&L employees

(viz., Mr. Chan and John Vay) establishes that tax avoidance was

not a significant purpose for the formation of B&L Hong Kong, the

record is silent, particularly with respect to petitioners'

taxable years ended December 25, 1983, through December 28, 1986,



45
   Petitioners argue that B&L Hong Kong's interest income at
issue is excludible from their gross income pursuant to sec.
954(b)(3)(A). The record does not establish the total amount of
B&L Hong Kong's foreign base company income (determined without
regard to sec. 954(b)(2) and (5)) for any of the taxable years
ended Dec. 25, 1983, through Dec. 28, 1986. Consequently, we are
unable to determine whether B&L Hong Kong's interest income (or
any other foreign base company income that we have found herein)
is excludible pursuant to sec. 954(b)(3)(A).
                              - 103 -


as to petitioners' purpose for structuring as they did the trans-

actions that gave rise to B&L Hong Kong's income at issue from

the sale of B&L products it did not assemble.

     In addition, the type of business carried on by B&L Hong

Kong that gave rise to the income at issue from the sale of B&L

products it did not assemble was a sales business that derived

income from the sale of B&L products that it (1) purchased from

its parent or other related companies, (2) sold for use or con-

sumption outside Hong Kong, and (3) did not manufacture or as-

semble in Hong Kong.   Thus, the class of income at issue that B&L

Hong Kong derived from that business was foreign base company

sales income as defined in section 954(d)(1).

     Petitioners concede that the tax rates in Hong Kong were

lower than the tax rates in the United States.   Moreover, the

record shows that B&L's management was aware of the differences

between the tax rates in Hong Kong and the United States during

and immediately prior to the years at issue and that B&L's man-

agement made efforts during those years to reduce its overall tax

burden.

     Although most of B&L Hong Kong's sales activity may have

occurred in Hong Kong, the fact that the income at issue of B&L

Hong Kong from the sale of B&L products it did not assemble was

derived from the sale of those products for use or consumption

outside Hong Kong indicates to us that B&L Hong Kong's customers
                             - 104 -


were located outside Hong Kong.

     In sum, the present record does not support a finding that

respondent abused her discretion by failing to determine that the

transactions that gave rise to B&L Hong Kong's income at issue

from the sale of B&L products it did not assemble were not ef-

fected for a significant purpose of reducing taxes.   In fact, the

record does not even support a finding that tax reduction was not

a significant purpose for effecting those transactions.

     Based on our review of the entire record before us, we find

that petitioners failed to prove that respondent abused her

discretion by failing to conclude that the transactions that gave

rise to B&L Hong Kong's income at issue from the sale of B&L

products it did not assemble and from interest were not effected

for a significant purpose of reducing taxes for their taxable

years ended December 25, 1983, through December 28, 1986.46

Accordingly, we hold that respondent did not abuse her discretion

under section 954(b)(4) by failing to exclude that income from

petitioners' gross income for those years.

     To reflect the foregoing and the concessions of the parties,

                                        Decision in docket No.

                                   13983-91 will be entered under

                                   Rule 155.


46
   Although we do not address herein every argument advanced by
petitioners under sec. 954(b)(4), we have considered all of their
arguments and find them to be without merit.
