Computer Company Disputes Reallocation of Income

Adaptec states that it is a leading supplier of computer hardware and software. AMS was formed in 1987, Adaptec explains, to be a self-sufficient operation carrying out all offshore manufacturing operations for products manufactured in the Far East for Adaptec. The company maintains that AMS handles each phase of the process for Adaptec products, from manufacturing to shipping, more efficiently than an outside entity.

In that regard, Adaptec clarifies that AMS received insufficient compensation for (a) the functions and risks it assumed in manufacturing Adaptec products; (b) providing Adaptec with unique manufacturing know-how and expertise; and (c) the economic benefits Adaptec achieved from the quality and reliability of products manufactured by AMS. Adaptec states that for these reasons, it filed a claim and election for setoffs under section 482 and that it is entitled to these setoffs against the adjustments proposed in the notice of deficiency.

Adaptec is also disputing the determination that it received constructive dividends from deposits made by AMS with Taiwan Semiconductor Manufacturing Corp, an unrelated party. Further, the company contests a proposal to increase taxable income based on royalties paid by AMS to Adaptec.

PETITION

Adaptec, Inc., (hereinafter "Petitioner") hereby, for itself and on behalf of its consolidated subsidiaries, petitions for a redetermination of the deficiencies set forth by the Commissioner of Internal Revenue ("Respondent") in his Notice of Deficiency dated June 27, 2000. As the basis for its case, Petitioner alleges as follows:

1. Petitioner is a corporation organized and existing under the laws of the State of Delaware, with its principal office at 691 South Milpitas Blvd. (MS 125), Milpitas, CA 95035-5473. Petitioner's taxpayer identification number is [TIN omitted]. The consolidated federal income tax returns of Petitioner for the taxable years ending March 31, 1994, 1995 and 1996 were filed with the Office of the Internal Revenue Service at Fresno, California. For the periods involved, Petitioner kept its books and filed its federal income tax returns on the basis of the accrual method of accounting.

2. The Notice of Deficiency ("Notice") (a copy of which is attached hereto and marked Exhibit A in exactly the form in which it was received by Petitioner and including all accompanying statements and schedules) was dated and presumably mailed to Petitioner on or about June 27, 2000, and issued by the Office of the District Director, Internal Revenue Service at San Jose, California.

3.a. The deficiencies as determined by Respondent are in corporate income taxes for the taxable years ending March 31, 1994 ("FY94"), March 31, 1995 ("FY95") and March 31, 1996 ("FY96") (collectively, the "audit years" or "years at issue"), in the amounts of $9,184,355, $16,014,851 and $70,820,855, respectively, all of which is in dispute. Respondent also proposed additions to tax under section 6662 of the Internal Revenue Code of 1986, as amended (the "Code") for the taxable years ending March 31, 1994, 1995 and 1996, in the amounts of $1,836,871, $5,761,433 and $26,729,485, respectively, all of which is in dispute.

3.b. As affirmative claims, Petitioner also claims additional overpayments of tax in the amount of $666,007, or in such other amount as the Court may determine, arising out of corrections to the credit claimed in Petitioner's taxable year ended March 31, 1996, under I.R.C. section 41; and additional overpayments of tax resulting from overpayments by AMS to Petitioner arising from controlled transactions during each of the years at issue.

3.c. For each of the years at issue, Petitioner also claims all correlative adjustments allowable by law, including, without limitation, adjustments relating to foreign tax credits or previously taxed earnings and profits, and any carrybacks or carryovers relating thereto.

4. The determination of tax and penalties set forth in the Notice is based in part on the following errors:

4.a. Respondent erred in increasing Petitioner's taxable income resulting from adjustments to the transfer price for goods purchased by Petitioner from Adaptec Manufacturing (S) Pte. Ltd. ("AMS") in the amounts of $16,416,000, $38,742,000, and $19,937,000, for Petitioner's taxable years ended March 31, 1994, March 31, 1995, and for the period from April 1, 1995 through August 31, 1995, in Petitioner's taxable year ended March 31, 1996, respectively. Exhibit A, Form 4559-B; Explanation of Tax Changes, unnumbered page 1.

4.b. Respondent erred in determining that Petitioner received constructive dividends in the amounts of $9,766,666, $4,639,167, and $14,476,000, during Petitioner's taxable years ended March 31, 1994, 1995 and 1996, respectively, attributable to deposits made by AMS with Taiwan Semiconductor Manufacturing Corporation, an unrelated party. Exhibit A, Form 4559-B; Explanation of Tax Changes, unnumbered page 1.

4.c. Respondent erred in increasing Petitioner's taxable income in the amount of $154,576,845 for Petitioner's taxable year ended March 31, 1996, resulting from increases in royalties paid by AMS to Petitioner during FY96. Exhibit A, Form 4559-B; Explanation of Tax Changes, unnumbered page 1.

4.d. Respondent erred in increasing Petitioner's taxable income in the amount of $8,478,500, resulting from adjustments to the transfer price for tangible goods purchased by Petitioner from AMS during the period from September 1, 1995 through March 31, 1996, in Petitioner's taxable year ended March 31, 1996. Exhibit A, Form 4559- B; Explanation of Tax Changes, unnumbered page 1.

4.e. Respondent erred in proposing additions to tax under I.R.C. section 6662 in the amounts of $1,836,871, $5,761,433 and $26,729,485, for Petitioner's taxable years ended March 31, 1994, March 31, 1995, and March 31, 1996, respectively. Exhibit A, Form 4559-A; Explanation of Tax Changes, unnumbered pages 2 and 3.

4.f. Respondent erred in making correlative adjustments set forth in the Notice for the years at issue. Exhibit A, Form 4559-B; Explanation of Tax Changes, unnumbered pages 1 and 2. Each of these correlative adjustments are based on the determinations made by Respondent in the Notice to which error has been assigned in this petition, and are incorrect for the reasons stated in paragraphs 5.a through 5.f, infra. To the extent that any of the adjustments proposed in the Notice are sustained, Respondent erred in not making all requisite correlative adjustments.

4.g. As affirmative claims, Petitioner is entitled to additional credits under I.R.C. section 41 for its taxable year ended March 31, 1996, and additional adjustments relating to overpayments of tax during each of the years at issue resulting from overpayments by AMS to Petitioner arising from controlled transactions.

5. The facts upon which Petitioner relies, as the basis of its case, are as follows:

a. RESPONDENT'S PROPOSAL TO INCREASE PETITIONER'S TAXABLE INCOME

(2) These devices include computer hard disk, optical and tape storage devices, and network file servers.

(3) Adaptec's products include single-chip host adapters, host adapter boards, ATM network interface boards, integrated circuit ("IC") products, internal and external cables and related products.

(4) Adaptec's host adapter products are based on the Small Computer Systems Interface ("SCSI") standard, which interfaces with all standard microcomputer architectures.

(5) Adaptec's broad-based solutions range from simple connectivity products for single-user and small-office desktop computers, to intelligent subsystems and high-performance SCSI, RAID (Redundant Array of Independent Disks), and ATM (Asynchronous Transfer Mode) products for enterprise-wide computing and networked environments.

(6) During the years at issue, Adaptec's integrated circuit products included single chip disk controllers for disk drives and single-chip SCSI host adapters.

(7) During the years at issue, Adaptec also made board-based versions of its host adapter products and CD-recordable software solutions.

(8) Adaptec caters to original equipment manufacturers (OEMs), system integrators, and end users.

(9) Adaptec sells its products through both OEM and distributor channels.

(10) Products in Adaptec's industry are typically short-lived.

(11) "Time to market" and "time to volume" are crucial considerations for Adaptec.

(12) AMS was formed in or about January, 1987 and at all times since has been a wholly owned subsidiary of Petitioner.

(13) Neither Petitioner nor AMS have ever owned a semiconductor fabrication facility ("fab").

(14) Manufacturers who rely on third-party semiconductor foundries for their supply of ICs are commonly referred to as "fabless" manufacturers.

(15) Petitioner and AMS are fabless manufacturers.

(16) Prior to 1987, Petitioner used unrelated contract manufacturers to manufacture its printed circuit boards ("PCBs").

(17) Most of these contract manufacturers were located in the Far East.

(18) Prior to 1987, Petitioner carried out in-house all the testing, rework and packaging for shipment for the PCBs manufactured by unrelated contract manufacturers.

(19) AMS was established to be a self-sufficient, offshore manufacturing operation carrying out all manufacturing operations for products being manufactured for Petitioner by the independent contract manufacturers located in the Far East.

(20) To accomplish this objective, AMS sequentially assumed each step or function in the manufacturing process, beginning with functional testing of board products.

(21) In August of 1987, AMS began running functional testing on the host adapter boards manufactured by third-party board manufacturers.

(22) In 1987, AMS personnel also began performing on-site inspections of the board manufacturers.

(23) Each time AMS took over an additional manufacturing step or function, it improved on the quality and value of the step or function as previously performed by the contract manufacturers.

(24) Reducing manufacturing costs, manufacturing delays and processing delays associated with the production of IC and board products has historically been an important business priority for Petitioner and AMS.

(25) AMS has designed and optimized its manufacturing operations specifically to meet the needs of Petitioner.

(26) From the beginning of its manufacturing activities, AMS has emphasized both cost-effective manufacturing and manufacturing quality.

(27) The quality of products manufactured by AMS has consistently exceeded the quality of the products previously manufactured by contractors for Petitioner.

(28) AMS's high-quality manufacturing is necessary for sales by Petitioner to its OEM customers.

(29) AMS's success in attaining the highest standards of quality and reliability has been a significant contributor to Petitioner's brand equity and goodwill.

(30) AMS's activities and functions significantly exceed those of a typical contract manufacturer.

(31) AMS handles each phase of the process for Adaptec products, from manufacture to shipping, more efficiently than any contract manufacturer that might otherwise be used.

(32) Prior to September 1, 1995, AMS had already developed and owned valuable proprietary manufacturing intangibles.

(33) AMS bears production and inventory risk.

(34) During the years at issue, AMS was responsible for all orders of raw materials and supplies other than ICs, and assumed the risk of holding the associated inventory.

(35) AMS manages relationships with outside suppliers and vendors for Adaptec products.

(36) Since January 1, 1995, AMS has directly procured the vast majority of ICs utilized in Adaptec products and has assumed the risk of holding the associated inventory.

(37) Petitioner's and AMS's management decided during 1993 that AMS would directly procure the ICs used in Adaptec products.

(38) AMS purchases the ICs used in Adaptec products directly from unrelated semiconductor foundries.

(39) AMS's assumption of purchasing and procurement of semiconductors was one of the many steps Petitioner and AMS took in their continuing efforts to streamline and improve the manufacturing and delivery of Adaptec products.

(40) AMS's manufacturing operation has been exclusively to manufacture Adaptec PCBs and ICs.

(41) As a result, AMS has customized and optimized its operations to manufacture Adaptec products.

(42) Since its incorporation, AMS has significantly reduced the manufacturing costs associated with the production of Adaptec's ICs and board products.

(43) Since its incorporation, AMS has significantly reduced the manufacturing and processing delays associated with the production of ICs and board products.

(44) Adaptec has achieved significant cost efficiencies as a result of AMS's specialized manufacturing activities.

(45) AMS sold its manufactured products to both related parties and to unrelated third parties during its taxable year ended March 31, 1996.

(46) AMS did not receive adequate compensation from Petitioner for the functions and risks it assumed in manufacturing Adaptec products during the years at issue.

(47) AMS did not receive adequate compensation for providing Petitioner with unique manufacturing know-how and expertise that significantly benefited Petitioner during the years at issue.

(48) Petitioner did not provide AMS with adequate compensation for the economic benefits Petitioner achieved from the quality and reliability of products manufactured by AMS.

(49) On July 25, 2000, Petitioner timely filed a claim and election for setoffs under I.R.C. section 482 with Peggy C. Rule, District Director (the "Setoff Request").

(50) Petitioner is entitled to setoffs against the section 482 adjustments proposed in the Notice.

b. RESPONDENT ERRED IN DETERMINING PETITIONER RECEIVED

(2) AMS has never remitted a dividend directly to Petitioner in the amount of $9,766,666.

(3) AMS has never remitted a dividend directly to Petitioner in the amount of $4,639,167.

(4) AMS has never remitted a dividend directly to Petitioner in the amount of $14,476,000.

(5) Petitioner did not directly receive a dividend from AMS in the amount of $9,766,666 at any time during the years at issue.

(6) Petitioner did not directly receive a dividend from AMS in the amount of $4,639,167 at any time during the years at issue.

(7) Petitioner did not directly receive a dividend from AMS in the amount of $14,476,000 at any time during the years at issue.

(8) Since its incorporation in January of 1987, AMS's responsibilities in relation to the procurement, testing and manufacturing of Adaptec products have steadily increased.

(9) Reducing manufacturing costs, manufacturing delays and processing delays associated with the production of IC and board products has historically been an important business priority for Petitioner and AMS.

(10) Prior to the incorporation of AMS, ICs were first shipped from the fabrication facility to Petitioner's facilities in California.

(11) Prior to the incorporation of AMS, once the ICs were shipped from the fabrication facility to Petitioner's facilities in California, Petitioner tested the vast majority of ICs for defects (the "wafer probe").

(12) Third-party contractors located in the United States tested a de minimis percentage of the ICs.

(13) Prior to the incorporation of AMS, following the wafer probe, Petitioner shipped the tested wafers to third-party assemblers in Asia for cutting into separate ICs and packaging. A de minimis percentage of wafers were cut and packaged in the United States.

(14) Prior to the incorporation of AMS, once the wafers were cut and packaged, the ICs were shipped back to Petitioner's facilities in California where a final test of the ICs was conducted.

(15) Prior to the incorporation of AMS, once Petitioner completed the final test of the ICs, the ICs were either sold to customers as IC products or incorporated into host adapter board products.

(16) Prior to the incorporation of AMS, the vast majority of IC products were shipped a minimum of three times between the Far East and the United States prior to being sold to customers: (a) from the fab to Petitioner for the wafer probe; (b) from Petitioner to the cutting/packaging house in Asia; and (c) from the cutting/packaging house in Asia back to Petitioner for final testing.

(17) Prior to the incorporation of AMS, the ICs sold to customers in Asia were shipped a minimum of four times between Asia and the United States.

(18) During the years at issue, a large percentage of Petitioner's customers for its IC products were located in Asia.

(19) Prior to the incorporation of AMS, third-party contract manufacturers located in Singapore manufactured Adaptec's host adapter board products.

(20) Prior to the incorporation of AMS, the host adapter boards were shipped from the third-party contractors to Petitioner's facilities in California for final functional testing.

(21) Prior to AMS's incorporation, after Petitioner completed final testing of the boards in the United States, Petitioner shipped the host adapter boards to its customers.

(22) Prior to AMS's incorporation, the vast majority of ICs in the host adapter board products were shipped a minimum of five times between the Far East and the United States: (a) from the fab in Asia to Petitioner for the wafer probe; (b) from Petitioner to the cutting/packaging house in Asia; (c) from Asia to Petitioner for final testing; (c) from Petitioner to the host adapter board manufacturer in Singapore; and (e) from the board manufacturer back to Petitioner for testing prior to shipment to customers.

(23) The host adapter boards manufactured by the third-party subcontractors frequently did not satisfy Petitioner's quality standards and required substantial re-work.

(24) Testing of the boards in the United States, coupled with the high failure rates and substantial amounts of re-work performed by Petitioner, resulted in high freight costs, caused significant production delays, added substantial costs, and reduced profit margins on the board products.

(25) From its incorporation to the present time, AMS and its personnel have worked directly with Petitioner's management in an effort to streamline the IC production and host adapter board manufacturing process.

(26) In August, 1987, AMS began running functional testing on the host adapter boards manufactured by third-party board manufacturers.

(27) In November, 1988, AMS purchased its first SMT line from a third-party vendor and began manufacturing host adapter boards.

(28) Prior to 1991, AMS shipped completed boards to Petitioner for a final test audit.

(29) After the final test audit, Petitioner shipped the boards to customers, some of which were located in Asia.

(30) In 1991, AMS started performing the final test audits on the completed boards.

(31) In 1991, AMS began drop-shipping the board products to Petitioner's customers directly.

(32) By carrying out the final test audit of the board products and drop-shipping boards directly to customers, AMS reduced overall freight costs and substantially improved the response time on deliveries of Adaptec board products.

(33) During its taxable years ended March 31, 1994, through March 31, 1996, Petitioner maintained only a prototype host adapter board hand-placement manufacturing facility in Milpitas, California.

(34) Petitioner's prototype host adapter board hand-placement manufacturing facility was limited to manufacturing prototype models of Adaptec's board products.

(35) AMS's hoard manufacturing lines include an in-line manufacturing process with automated component placement equipment.

(36) AMS's in-line board manufacturing process enables AMS to run high volume production of host adapter boards.

(37) During its taxable years March 31, 1994, through March 31, 1996, Petitioner did not have the manufacturing capability to run high volume production of host adapter boards.

(38) AMS's innovations in the host adapter board manufacturing process substantially increased gross margins realized on Adaptec's board-based products.

(39) During the early 1990's management teams from AMS and Petitioner considered additional ways to use AMS's capabilities to streamline the IC testing process.

(40) The final testing of production ICs was one of the areas of IC production considered by Petitioner and AMS.

(41) AMS personnel made numerous presentations to Petitioner's management regarding the benefits of moving the final testing of production ICs to AMS.

(42) AMS and Petitioner's research confirmed that moving final testing of production ICs to AMS would decrease the time for integrating production ICs into Adaptec's board-based products.

(43) In 1992, management from Petitioner and AMS decided AMS should engage in final testing of production ICs.

(44) AMS began conducting the final testing of production ICs in November, 1992.

(45) By relocating the final testing of production ICs to AMS, the freight costs and production times for ICs, as well as for Adaptec's board-based products, were significantly reduced.

(46) Petitioner continued to maintain its IC testing equipment at its Milpitas facilities after AMS began conducting production- level IC testing.

(47) During the years at issue Petitioner's IC testing facilities were utilized almost exclusively to perform alpha- and beta-stage testing of prototype, pre-production ICs and testing of early production-stage ICs.

(48) By 1993, AMS was engaged in, or plans had been adopted for AMS to begin performing, the majority of functions related to IC testing and host adapter board manufacturing.

(49) The only aspects of IC production that A-MS was not engaged in or planning to engage in by 1993 were the IC procurement function and responsibility for the initial wafer probe testing.

A. THE FOUNDRY AGREEMENT.

(50) On October 29, 1993, Petitioner and Taiwan Semiconductor Manufacturing Corporation ("TSMC"), a foreign semiconductor foundry, entered into a contract entitled "Foundry Agreement."

(51) No common shareholder(s) of Petitioner and TSMC control(s) both entities.

(52) Petitioner and TSMC are not related parties.

(53) Petitioner agreed to purchase prototype semiconductor wafers from TSMC, and TSMC agreed to produce prototype wafers in accordance to design specifications submitted by Petitioner.

(54) Petitioner entered into the Foundry Agreement in order to support its research and development of ICs and board-based products.

(55) Petitioner did not have the equipment or expertise to operate the semiconductor fabrication equipment necessary to produce prototype ICs.

(56) Petitioner and TSMC were the only parties to the Foundry Agreement.

(57) AMS was not a party to the Foundry Agreement.

(58) Petitioner's employees represented Petitioner in the negotiation of the Foundry Agreement.

(59) AMS employees did not participate in the negotiation of the Foundry Agreement.

(60) Petitioner and TSMC agreed that Petitioner could order small lots (individual orders) of prototype ICs.

(61) Petitioner and TSMC agreed that TSMC would use its "best efforts" to satisfy all orders placed by Petitioner.

(62) Petitioner and TSMC agreed that Petitioner could terminate the Foundry Agreement at any time following six months prior written notice.

(63) The terms and conditions set forth in the Foundry Agreement represent the final and entire agreement between Petitioner and TSMC.

B. THE SUPPLY AGREEMENT.

(64) During the early 1990's, there was a significant shortage of semiconductor foundry capacity among the independent semiconductor foundries.

(65) This production capacity shortage placed significant pressures on fabless semiconductor manufacturers.

(66) Due to the semiconductor manufacturing capacity shortages during the early 1990s, independent semiconductor foundries were in an advantageous position with respect to the negotiation of contracts with the fabless semiconductor producers.

(67) During 1993, management from Petitioner and AMS agreed that AMS would be responsible for directly procuring ICs.

(68) By shifting IC procurement activities to AMS, the production and testing of ICs, as well as the manufacturing of the host adapter boards, became centralized within Adaptec.

(69) To reduce its risks associated with the procurement of ICs, AMS sought to secure a guaranteed level of semiconductor fabrication capacity through an agreement with TSMC.

(70) In order to conduct its manufacturing operations, AMS needed to ensure a steady supply of the ICs utilized in Adaptec products.

(71) On October 29, 1993, AMS entered into a contract with TSMC entitled "Deposit and Supply Agreement" (the "Supply Agreement").

(72) AMS agreed to purchase a specific number of ICs from TSMC.

(73) In turn, TSMC agreed to provide a guaranteed level of IC production capacity to AMS.

(74) AMS agreed to deposit funds with TSMC to guarantee the wafer capacity TSMC was obligated to deliver under the Supply Agreement (the "Supply Agreement Deposit").

(75) No common shareholder(s) of AMS and TSMC control(s) both entities.

(76) AMS and TSMC are not related parties.

(77) The Supply Agreement was executed on the same date as the Foundry Agreement.

(78) The Supply Agreement and the Foundry Agreement were negotiated separately.

(79) AMS and TSMC were the only parties to the Supply Agreement.

(80) Petitioner was not a party to the Supply Agreement.

(81) Petitioner's employees assisted AMS in the negotiation of the Supply Agreement.

(82) To the extent Petitioner's employees assisted with the negotiation of the Supply Agreement, Petitioner charged AMS for all costs and expenses it incurred in connection with the negotiation of the Supply Agreement.

(83) AMS representatives participated in the planning and negotiation of the Supply Agreement.

(84) AMS's Managing Director and Director of Finance reviewed and approved the Supply Agreement before that agreement was executed.

(85) AMS's board of directors approved the terms of the Supply Agreement pursuant to a document entitled "Written Consent of the Board of Directors of Adaptec Mfg (S) Pte Ltd" (the "Written Consent"), effective October 28, 1993.

(86) The Written Consent expressly approved AMS's payment of the Supply Agreement Deposit.

(87) The Written Consent specifically appointed Petitioner to act as AMS's agent for the purposes of executing purchase orders and other tasks as needed.

(88) AMS paid the Supply Agreement Deposit directly to TSMC via a wire transfer from AMS's bank account in the United States directly to TSMCI's bank account.

(89) AMS reflected in its accounting records the Supply Agreement Deposit it paid to TSMC.

(90) The Supply Agreement Deposit paid by AMS to TSMC was never reflected in Petitioner's accounting records.

(91) Petitioner never obtained legal title to or control of any portion of the Supply Agreement Deposit.

(92) AMS retained legal control at all times, subject to the terms of the Supply Agreement, of the Supply Agreement Deposit.

(93) TSMC returned the Supply Agreement Deposit directly to AMS on May 30, 1997.

(94) The Supply Agreement incorporated by reference the wafer specifications, delivery terms, pricing and confidentiality provisions as set forth in the Foundry Agreement.

(95) The terms and conditions set forth in the Supply Agreement represent the final and entire agreement between AMS and TSMC.

C. THE "OPTION 1" AGREEMENT

(96) On October 23, 1995, AMS entered into a contract with TSMC entitled "Option Agreement 1."

(97) AMS entered into Option Agreement 1 to secure a guaranteed supply of ICs utilized in Adaptec products.

(98) AMS agreed to purchase a specific number of ICs from TSMC.

(99) In turn, TSMC agreed to provide a guaranteed level of IC production capacity to AMS.

(100) AMS agreed to deposit funds with TSMC to guarantee the wafer capacity TSMC was obligated to deliver under Option Agreement 1 (the "Option Agreement 1 Deposit").

(101) AMS representatives directly participated in the negotiation of Option Agreement 1.

(102) AMS's Managing Director and Director of Finance reviewed and approved Option Agreement 1 before that agreement was executed.

(103) AMS and TSMC were the only parties to Option Agreement 1.

(104) Petitioner was not a party to Option Agreement 1.

(105) AMS paid the Option Agreement 1 Deposit directly to TSMC via a wire transfer from AMS's bank account in the United States directly to TSMC's bank account.

(106) AMS reflected in its accounting records the Option Agreement 1 Deposit it paid to TSMC.

(107) The Option Agreement 1 Deposit paid by AMS to TSMC was never reflected in Petitioner's accounting records.

(108) Petitioner never obtained legal title or control of any portion of the Option Agreement 1 Deposit.

(109) AMS retained legal control at all times, subject to the terms of Option Agreement 1, of the Option Agreement 1 Deposit.

(110) Unlike the Supply Agreement, TSMC was not obligated to return the Option Agreement 1 Deposit to AMS at the end of the Agreement.

(111) Instead, TSMC agreed to credit AMS with a portion of the Option Agreement 1 Deposit per wafer ordered from TSMC pursuant to Option Agreement 1.

(112) Option Agreement 1 incorporated by reference the specifications, delivery terms, pricing and confidentiality provisions as set forth in the Foundry Agreement.

(113) The terms and conditions set forth in Option Agreement 1 represent the entire agreement between AMS and TSMC with respect to the subject matter set forth in Option Agreement 1.

D. THE "OPTION 2" AGREEMENT

(114) On October 23, 1995, AMS entered into a contract with TSMC entitled "Option Agreement 2."

(115) AMS entered into Option Agreement 2 to secure a guaranteed supply of ICs utilized in Adaptec products.

(116) AMS agreed to purchase a specific number of ICs from TSMC.

(117) In turn, TSMC agreed to provide a guaranteed level of IC production capacity to AMS.

(118) AMS agreed to deposit funds with TSMC to guarantee the wafer capacity TSMC was obligated to deliver (the "Option Agreement 2 Deposit").

(119) AMS representatives directly participated in the negotiation of Option Agreement 2.

(120) AMS's Managing Director and Director of Finance reviewed and approved Option Agreement 2 before that agreement was executed.

(121) AMS and TSMC were the only parties to Option Agreement 2.

(122) Petitioner was not a party to Option Agreement 2.

(123) AMS paid the Option Agreement 2 Deposit directly to TSMC via a wire transfer from AMS's bank account in the United States directly to TSMC's bank account.

(124) AMS reflected in its accounting records the Option Agreement 2 Deposit it paid to TSMC.

(125) The Option Agreement 2 Deposit paid by AMS to TSMC was never reflected in Petitioner's accounting records.

(126) Petitioner never obtained legal title or control of any portion of the Option Agreement 2 Deposit.

(127) AMS retained legal control at all times, subject to the terms of Option Agreement 2, of the Option Agreement 2 Deposit.

(128) Unlike the Supply Agreement, TSMC was not obligated to return the Option Agreement 2 Deposit to AMS at the end of the Agreement.

(129) Instead, TSMC agreed to credit AMS with a portion of the Option Agreement 2 Deposit per wafer ordered from TSMC pursuant to Option Agreement 2.

(130) Option Agreement 2 incorporated by reference the specifications, delivery terms, pricing and confidentiality provisions as set forth in the Foundry Agreement.

(131) The terms and conditions set forth in Option Agreement 2 represented the entire agreement between AMS and TSMC with respect to the subject matter set forth in Option Agreement 2.

(132) AMS never lost control of the funds it deposited with TSMC pursuant to the Supply Agreement, Option Agreement, 1 or Option Agreement 2.

(133) Petitioner never had actual or constructive control of any of the funds AMS deposited with TSMC pursuant to the Supply Agreement, Option Agreement 1, or Option Agreement 2.

(134) Respondent therefore erred in determining Petitioner received constructive dividends from AMS attributable to the deposits made by AMS with TSMC pursuant to the Supply Agreement, Option Agreement 1, and Option Agreement 2.

(135) AMS undertook and assumed various services, functions and risks in connection with transfers of funds to and from TSMC.

(136) To the extent that Respondent claims that AMS undertook and assumed these services, functions and risks on Petitioner's behalf, Petitioner did not provide AMS with adequate arm's-length compensation for undertaking and assuming these services, functions and risks.

C. RESPONDENT'S PROPOSAL TO INCREASE PETITIONER'S TAXABLE INCOME

(2) Petitioner was founded in 1981 and became a public company in 1986.

(3) AMS was established in 1987 as a wholly owned subsidiary of Petitioner.

(4) Petitioner and AMS are engaged in the business of designing, developing, manufacturing, marketing and selling input/output products for the computer industry.

(5) Since no later than September 1, 1995, AMS has been continuously engaged in the business of designing, developing, manufacturing, marketing and selling input/output products for the computer industry.

(6) The computer industry is characterized by rapid innovation.

(7) It is common practice in Petitioner's industry for unrelated parties to enter into licenses of intangibles with royalties defined as a percentage of the licensee's sales.

(8) Five-year old technology in the computer industry is generally of little or no interest to potential licensees.

(9) Petitioner's five-year old technology is of little or no interest to potential licensees.

(10) No unrelated party currently pays Petitioner a royalty for the use of any of Petitioner's five-year old technology.

(11) Effective September 1, 1995, Petitioner and AMS entered into a Technology Research and Development Cost and Risk Sharing Agreement (the "Cost Sharing Arrangement").

(12) During the period from September 1, 1995, through March 31, 1996, the Cost Sharing Arrangement was a bona fide cost sharing arrangement under Temporary Treasury Regulation section 1.482-7T.

(13) During the period from September 1, 1995, through March 31, 1996, AMS made royalty payments to Petitioner for the technology Petitioner licensed to AMS pursuant to the Cost Sharing Arrangement.

(14) Respondent proposes an adjustment in the amount of $154,576,845 (the "Proposed Adjustment") to the royalties paid by AMS to Petitioner pursuant to the Cost Sharing Arrangement, during Petitioner's taxable year ending March 31, 1996.

(15) Respondent attached to the Notice no explanation or support for the Proposed Adjustment other than the following statement: "In accordance with section 482 of the Internal Revenue Code, to clearly reflect the income of the entities, we have allocated income and deductions in connection with the Cost Sharing Arrangement, effective September 1, 1995, between Adaptec and Adaptec Manufacturing Singapore. Your income has been increased as shown in the attached computation."

(16) The Proposed Adjustment would leave AMS with a loss for its taxable year ended March 31, 1996.

(17) In order for the royalties paid by AMS to Petitioner pursuant to the Cost Sharing Arrangement to be arm's length in nature, they must be based on the income AMS earned from use of the technology that Petitioner licensed to AMS pursuant to the Cost Sharing Arrangement.

(18) During the period from September 1, 1995, through March 31, 1996, the income AMS earned from its use of licensed technology was income from sales to unrelated parties and from sales to Petitioner.

(19) The royalties paid by AMS to Petitioner pursuant to the Cost Sharing Arrangement during Petitioner's taxable year ending March 31, 1996, exceeded the royalties that Petitioner could have expected at arm's length.

(20) Pursuant to the Cost Sharing Arrangement, Petitioner and AMS agreed to share research and development costs, determined consistently with United States Generally Accepted Accounting Principles, incurred by Petitioner and AMS in proportion to the reasonably anticipated benefits to be derived by each party from selling products utilizing or incorporating intangible property developed after September 1, 1995.

(21) During the period from September 1, 1995, through March 31, 1996, Petitioner and AMS made cost sharing payments in accordance with the terms of the Cost Sharing Arrangement.

(22) The Cost Sharing Arrangement was terminable for convenience by Petitioner or AMS upon sixty days written notice.

(23) The Cost Sharing Arrangement qualifies as a qualified cost sharing arrangement under Treasury Regulation section 1.482-7.

(24) AMS received a smaller share of Adaptec's combined sales income than AMS's share of research and development costs as specified in the Cost Sharing Arrangement.

(25) AMS received a smaller share of Adaptec's profits during the period from September 1, 1995, through March 31, 1996, than the share of research and development costs borne by AMS during the same period.

(26) AMS received a smaller share of Adaptec's profits during the period from September 1, 1995, through March 31, 2000, than the share of research and development costs borne by AMS during the same period.

(27) The cost sharing payments made by AMS during the period from September 1, 1995, through March 31, 1996, resulted in an overpayment.

(28) The cost sharing payments made by AMS during the period from September 1, 1995, through March 31, 2000, resulted in an overpayment.

(29) Pursuant to the Cost Sharing Arrangement, Petitioner and AMS each received perpetual and nonexclusive manufacturing rights, assembly and testing rights, and selling and use rights with respect to any and all patents, copyrights, trade secrets and similar property rights, and any micro code, process, technology, inventions, computer programs, enhancements, updates, translations, adaptations, information, data, specifications, designs, manufacturing techniques and descriptions, and other intangible property (whether or not in documentary form and whether or not patentable or copyrightable) that did not exist as of September 1, 1995 (collectively, "Developed Technology").

(30) During its taxable year ended March 31, 1996, Petitioner and AMS introduced products incorporating Developed Technology.

(31) The Cost Sharing Arrangement reflects an effort in good faith by Petitioner and AMS to bear their respective shares of all the costs and risks of development on an arm's length basis.

(32) As of August 31, 2000, AMS had made royalty payments and cost sharing payments to Petitioner pursuant to the terms of the Cost Sharing Arrangement for five years.

(33) It is appropriate for the royalty rates paid by AMS to Petitioner under the Cost Sharing Arrangement to decline over time.

(34) A declining royalty rate should reflect AMS's contribution to the development of new products and new intangibles and the increasing obsolescence of Petitioner's intangibles in existence as of September 1, 1995.

(35) The products produced by Petitioner and AMS in Petitioner's taxable year ended March 31, 1996, consisted primarily of: (a) peripheral technology solutions ("PTS") products, which are primarily hard disk drive controllers; and (b) host controller ("Host") products, which are controllers that allow servers and computers to utilize a variety of peripheral storage devices.

(36) During Petitioner's taxable year ended March 31, 1996, Petitioner and AMS's PTS products consisted primarily of single chip controllers that were embedded on hard disk drives.

(37) The key proprietary technology in Adaptec's Host products during Petitioner's taxable year ended March 31, 1996, was the underlying technology embodied in Petitioner and AMS's semiconductors.

(38) Adaptec's products are based in large part on nonproprietary industry standards.

(39) During its taxable year ended March 31, 1996, Petitioner's competitors included, among others, LSI Logic, NCR (Advansys), Initio, Future Domain, Qlogic and peripheral manufacturers.

(40) During its taxable year ended March 31, 1996, Petitioner lacked a "blocking" technology with which it could prevent competitor entry.

(41) Petitioner and AMS must constantly change their products and introduce new products in order to remain competitive.

(42) Petitioner and AMS must constantly change their products and introduce new products due to the introduction of increasingly powerful central processing units ("CPUs") that require more rapidly accessed and better managed data in order to function optimally.

(43) Petitioner and AMS must constantly change their products and introduce new products due to the introduction of new CPU bus architectures such as ISA, VESA and PCI.

(44) Petitioner and AMS must constantly change their products and introduce new products due to the introduction of new and modified operating systems such as Windows NT and Windows 98, which allow for faster input and output performance and multi-tasking.

(45) Petitioner and AMS must constantly change their products and introduce new products due to the growth of data-intensive software applications, such as graphics, audio and video, which require significantly more bandwidth.

(46) Petitioner and AMS must constantly change their products and introduce new products due to the proliferation of client/server networks, the Internet and corporate intranets.

(47) Petitioner and AMS must constantly change their products and introduce new products due to the growth in high-performance peripherals, such as high capacity hard disk drives, scanners, CD- ROMs and CD-R, CD-RW and DVD drives.

(48) Petitioner and AMS must constantly update their technology and develop new technologies in order to remain competitive.

(49) Petitioner and AMS must constantly update their technology and develop new technologies due to the introduction of increasingly powerful central processing units ("CPUs") that require more rapidly accessed and better managed data in order to function optimally.

(50) Petitioner and AMS must constantly update their technology and develop new technologies due to the introduction of new CPU bus architectures such as ISA, VESA and PCI.

(51) Petitioner and AMS must constantly update their technology and develop new technologies due to the introduction of new and modified operating systems such as Windows NT and Windows 98, which allow for faster input and output performance and multi-tasking.

(52) Petitioner and AMS must constantly update their technology and develop new technologies due to the growth of data-intensive software applications, such as graphics, audio and video, which require significantly more bandwidth.

(53) Petitioner and AMS must constantly update their technology and develop new technologies due to the proliferation of client/server networks, the Internet and corporate intranets.

(54) Petitioner and AMS must constantly update their technology and develop new technologies due to the growth in high-performance peripherals, such as high capacity hard disk drives, scanners, CD- ROMs and CD-R, CD-RW and DVD drives.

(55) Petitioner and AMS's customers for Host products generally demand the most advanced technology available at the time of the customer's product launch.

(56) Effective September 1, 1995, Petitioner and AMS entered into a Trademark License Agreement (the "Trademark License"), pursuant to which AMS received a nonexclusive license to use all trade names, trademarks, service marks, logos, trade dress and other trade designations adopted by, owned exclusively by, and registered to Petitioner as of September 1, 1995.

(57) Respondent does not challenge that AMS's payments under the Trademark License during its taxable year ending March 31, 1996, were arm's length in nature.

(58) During its taxable year ending March 31, 1996, AMS's payments under the Trademark License were arm's length in nature.

(59) Effective September 1, 1995, Petitioner and AMS entered into a Technology License Agreement (the "Technology License"), pursuant to which Petitioner licensed to AMS certain rights relating to the use of technology for the manufacturing, testing, assembling, using, selling and marketing of products that existed as of September 1, 1995.

(60) Respondent does not challenge that AMS's payments to Petitioner under the Technology License during its taxable year ending March 31, 1996, were arm's length in nature.

(61) During its taxable year ending March 31, 1996, AMS's payments to Petitioner under the Technology License were arm's length in nature.

(62) Respondent does not challenge Petitioner's measure of the useful life of its intangibles.

(63) Petitioner's measure of the useful life of its intangibles is reasonable.

(64) Petitioner's measure of the useful life of its intangibles is accurate.

(65) During its taxable year ended March 31, 1996, Petitioner and AMS introduced new products containing technology that had not existed prior to September 1, 1995.

(66) On July 25, 2000, Petitioner timely filed a claim and election for setoffs under I.R.C. section 482 with Peggy C. Rule, District Director (the "Setoff Request").

(67) Petitioner is entitled to setoffs against the section 482 adjustments proposed in the Notice.

d. RESPONDENT ERRED IN PROPOSING TO INCREASE PETITIONER'S

(2) Petitioner and AMS executed a Corporate Agreement, effective September 1, 1995.

(3) Petitioner and AMS agreed that Petitioner would distribute products manufactured by AMS in return for arm's length compensation.

(4) AMS did provide Petitioner with arm's length compensation for its distribution activities.

(5) Petitioner received arm's length compensation from AMS for its distribution activities during the period from September 1, 1995, through March 31, 1996.

(6) Respondent erred in proposing to increase Petitioner's taxable income in the amount of $8,478,500, resulting from adjustments to the transfer price for tangible goods purchased by Petitioner from AMS during the period from September 1, 1995, through March 31, 1996, in Petitioner's taxable year ended March 31, 1996.

(7) On July 25, 2000, Petitioner timely filed a claim and election for setoffs under I.R.C. section 482 with Peggy C. Rule, District Director (the "Setoff Request").

(8) Petitioner is entitled to setoffs against the section 482 adjustments proposed in the Notice.

e. RESPONDENT ERRED IN PROPOSING TO ASSESS PENALTIES UNDER

(2) Petitioner did not understate its income tax for any of the years at issue.

(3) Petitioner did not substantially understate its income tax for any of the years at issue.

(4) Petitioner had substantial authority for the positions it took on its income tax returns for each of the years at issue.

(5) Petitioner engaged in all necessary and appropriate investigations to determine that the positions it took on its income tax returns for each of the years at issue were correct.

(6) Petitioner sought and reasonably relied upon the advice of economic experts in filing its tax return for each of the years at issue.

(7) Petitioner acted reasonably and in good faith in taking the positions on its income tax returns as filed for each of the years at issue.

(8) In the event that there was underpayment of tax in any of the years at issue, such underpayment was not attributable to negligence or disregard of rules and regulations.

(9) Upon first learning that Respondent was considering the imposition of a penalty under I.R.C. section 6662 for FY96, Petitioner contacted Respondent to address the basis for the proposed penalty.

(10) Respondent's initial stated basis for the proposed penalty was that Petitioner had not met the contemporaneous documentation requirements of I.R.C. section 6662.

(11) Petitioner prepared a detailed written analysis of the reasons why the proposed penalty was not appropriate.

(12) Petitioner submitted this written analysis to Respondent.

(13) Respondent's examination team disagreed with Petitioner's written analysis.

(14) Respondent issued field service advice confirming that Respondent did not have a legitimate basis for holding that Petitioner had not met the contemporaneous documentation requirements of I.R.C. section 6662.

(15) After receiving the field service advice and before the Notice was issued, Respondent informed Petitioner that there would be no penalty imposed against Petitioner.

(16) Respondent did not provide Petitioner with any explanation for his change of position concerning imposition of penalties prior to issuing the Notice or in the Notice.

(17) Respondent did not provide Petitioner with an opportunity to discuss Respondent's change in position prior to issuance of the Notice.

(18) In the Notice, Respondent has abandoned his only basis previously discussed with Petitioner for concluding that Petitioner is liable for penalties on the alleged underpayment of taxes for FY96.

(19) Respondent refused Petitioner's request for an explanation of Respondent's changed basis for proposing penalties prior to issuance of the Notice.

(20) Respondent refused Petitioner's request for an opportunity to address Respondent's changed basis for proposing penalties prior to issuance of the Notice.

(21) In the Notice, Respondent maintains that penalties should be imposed because Petitioner has "not shown that [Petitioner] is not liable for said" penalties.

(22) In the Notice, Respondent proposes penalties significantly more expansive than any previously proposed.

f. RESPONDENT'S CORRELATIVE ADJUSTMENTS ARE ERRONEOUS.

(1) Petitioner realleges paragraphs 5.a.(1)-5.a.(50), 5.b.(1)- 5.b.(136), 5.c.(1)-(65), 5.d.(1)-5.d.(8), and 5.e(1)-5.e.(22).

(2) In the Notice, Respondent also made various correlative adjustments, based on certain other adjustments, to Petitioner's taxable income in FY94, FY95 and FY96.

(3) For the reasons stated in paragraphs 5.a through 5.d, Respondent erred in adjusting the amount of Petitioner's taxable income in each of the years FY94, FY95 and FY96. Accordingly, Respondent's correlative adjustments are also erroneous.

g. AS AFFIRMATIVE CLAIMS, PETITIONER IS ENTITLED TO

(2) Petitioner is entitled to claim additional credits under I.R.C. section 41 for its taxable year ended March 31, 1996, in the amount of $666,007.

(3) During each of the years at issue, AMS overpaid Petitioner in connection with controlled transactions between AMS and Petitioner.

(4) Petitioner is entitled to refunds for overpayments of tax resulting from the payment received from AMS on account of such transactions.

WHEREFORE, Petitioner prays that this Court hear this case and determine that:

1. Respondent erred as alleged in each assignment of error as set forth in paragraph 4 above.

2. There is no deficiency in income tax due from Petitioner for the taxable years ended March 31, 1994, 1995 and 1996.

3. Petitioner is entitled to refunds of overpayments as claimed herein, plus interest, in such amounts as the Court may determine.

4. Petitioner is entitled to all deductions and credits, and carrybacks and carryovers of all deductions and credits allowable by operation of law.

5. Petitioner is entitled to all correlative adjustments allowable by operation of law.

6. Petitioner is entitled to such other and further relief as the Court deems appropriate.

Date: September 25, 2000

[Editor's Note: The attachment has been omitted. However, this document in its entirety can be obtained through our Tax Analysts' Access Service as Doc 2000-26598 (105 pages).]