MEMORANDUM FINDINGS OF FACT AND OPINION

CHIECHI, Judge: Respondent determined the following deficiencies in petitioners' Federal income tax:

The following issues remain for decision: ¹1996 Tax Ct. Memo LEXIS 64">*65

(1) Does the income for each of the years at issue from the sale of sunglasses assembled ² 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 assembled ³ from petitioners' gross income for their taxable years ended December 25, 1983, through December 28, 1986? ⁴ We hold that she did not.

1996 Tax Ct. Memo LEXIS 64">*66 FINDINGS OF FACT ⁵

1996 Tax Ct. Memo LEXIS 64">*67 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 Kong1996 Tax Ct. Memo LEXIS 64">*68 within the meaning of section 951(b), B&L Ireland and B&L Hong Kong were controlled foreign corporations (CFCs) of petitioners 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, 1996 Tax Ct. Memo LEXIS 64">*69 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, ⁹1996 Tax Ct. Memo LEXIS 64">*70 binoculars, telescopes, 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 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 discontinued 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 countries.

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 efficiently serving the increasingly important European markets. Because of incentives, including tax benefits, offered by the Government of the Republic of Ireland (Ireland) to induce companies 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 manufacture1996 Tax Ct. Memo LEXIS 64">*71 contact lenses. B&L Ireland's contact 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 independent distributors unrelated to B&L (independent distributors) 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 that1996 Tax Ct. Memo LEXIS 64">*72 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 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 1996 Tax Ct. Memo LEXIS 64">*73 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 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 assemble in Hong Kong, and its largest sales market for those sunglasses was Hong Kong. Throughout1996 Tax Ct. Memo LEXIS 64">*74 the period 1972 through 1981, B&L Hong Kong, and not B&L Inc., made the decisions affecting 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 protection from the glare of the sun while flying above the clouds. B&L began marketing sunglasses to the general public in 1936. 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, 1996 Tax Ct. Memo LEXIS 64">*75 glass lenses that are impact resistant and designed to protect the wearer from harmful ultraviolet rays without distorting his or her natural vision.

B&L produced, inter alia, the following styles of sunglasses, 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 fronts ¹⁴ 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.

1996 Tax Ct. Memo LEXIS 64">*76 B&L used stock keeping units (SKUs) to keep track of the 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 different 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 produced 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 material1996 Tax Ct. Memo LEXIS 64">*77 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 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.¹⁵B&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 involved1996 Tax Ct. Memo LEXIS 64">*78 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 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 specifications that the parts and finished sunglasses were required to meet. Specifications for all sunglasses were established by the1996 Tax Ct. Memo LEXIS 64">*79 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. 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 the1996 Tax Ct. Memo LEXIS 64">*80 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 manufacturing 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 facility in Waterford, Ireland, to be located in the Waterford industrial estate in which B&L Ireland's1996 Tax Ct. Memo LEXIS 64">*81 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 1996 Tax Ct. Memo LEXIS 64">*82 approximate size of 6,700 square feet. At the same time, but in a separate agreement, the IDA also agreed to grant a rent subsidy to B&L Ireland 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, 1996 Tax Ct. Memo LEXIS 64">*83 Ireland generally exempted from that tax income earned through export sales of goods manufactured 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 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 addition1996 Tax Ct. Memo LEXIS 64">*84 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 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&L1996 Tax Ct. Memo LEXIS 64">*85 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 overall cost to B&L to produce a pair of sunglasses was reduced.

1996 Tax Ct. Memo LEXIS 64">*86 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 warehouse. 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 continued 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 Pursuant to those respective license agreements, B&L Inc. provided to B&L Ireland and B&L Hong Kong specifications for sunglass assembly, production know-how and training, ongoing technical assistance 1996 Tax Ct. Memo LEXIS 64">*87 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 assembly1996 Tax Ct. Memo LEXIS 64">*88 B&L sunglasses in accordance with the specifications for such sunglasses 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 coordination 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 personnel 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 at1996 Tax Ct. Memo LEXIS 64">*89 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 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 production1996 Tax Ct. Memo LEXIS 64">*90 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 production 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 production 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 consulting firms (1) to develop a job evaluation system for determining the1996 Tax Ct. Memo LEXIS 64">*91 relative level of skill required to perform the various 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 accounting 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 sunglass1996 Tax Ct. Memo LEXIS 64">*92 assembly operations: (1) A managing director who had overall responsibility 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 allocation, 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 by1996 Tax Ct. Memo LEXIS 64">*93 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.

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 historical data and time and motion studies. B&L Hong Kong's cost accounting system was indicative of a manufacturing company and not a distribution1996 Tax Ct. Memo LEXIS 64">*94 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 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. 1996 Tax Ct. Memo LEXIS 64">*95 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 parts, tools, and equipment he or she was to use. For the first week of training, the new operator assembled1996 Tax Ct. Memo LEXIS 64">*96 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 operator required approximately six months of assembly experience prior to reaching the1996 Tax Ct. Memo LEXIS 64">*97 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 transferred 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 quantity1996 Tax Ct. Memo LEXIS 64">*98 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 management and operators became more experienced in assembling those types of sunglasses. However, as new styles of sunglasses were 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 employees 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 Hong1996 Tax Ct. Memo LEXIS 64">*99 Kong's assistant 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 assembling 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 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 sunglasses 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.

1996 Tax Ct. Memo LEXIS 64">*100 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 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 1996 Tax Ct. Memo LEXIS 64">*101 Hong Kong) to identify and improve quality problems 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 inspection, a trained inspector selected a random sample of parts from each lot, examined the parts visually and with various gauges and tools to identify cosmetic or aesthetic defects and dimensional defects, and marked each defective part. The inspector compared the total1996 Tax Ct. Memo LEXIS 64">*102 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 quarantine. 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 defective1996 Tax Ct. Memo LEXIS 64">*103 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 repairable defective parts so that those parts could be used to assemble 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 1996 Tax Ct. Memo LEXIS 64">*104 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 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. 1996 Tax Ct. Memo LEXIS 64">*105 On the other hand, if the operator had not opened the lens screw far enough, the operator, by applying too much pressure trying to force the lens into place, might have chipped the lens, which would have caused the lens to be rejected as unacceptable 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 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, 1996 Tax Ct. Memo LEXIS 64">*106 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 operator 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 frequently encountered lens gap problems with respect to a style of metals called Caravans that had square rather than round eyepieces. This1996 Tax Ct. Memo LEXIS 64">*107 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 of the Caravans prior to assembly. At B&L Hong Kong, an individual 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 temple1996 Tax Ct. Memo LEXIS 64">*108 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 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, 1996 Tax Ct. Memo LEXIS 64">*109 the sunglasses 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 adjustments to eliminate them; (4) adjusted the nosepads; (5) examined 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 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) identified1996 Tax Ct. Memo LEXIS 64">*110 any rejected sunglasses and made the necessary repairs and/or replacements 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 necessary 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 specified quantity in a finished goods box. After completing the packing process, the packer verified the quantity in the box and completed a quality sheet.

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 standards. The auditor selected a random sample of 1996 Tax Ct. Memo LEXIS 64">*111 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 inspection, and the inspector would have corrected any defects identified 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 sunglasses. 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 functions 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

In addition to assembling metals, B&L Ireland's personnel1996 Tax Ct. Memo LEXIS 64">*112 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 responsible 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 without1996 Tax Ct. Memo LEXIS 64">*113 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 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 headcurve1996 Tax Ct. Memo LEXIS 64">*114 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 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 temple1996 Tax Ct. Memo LEXIS 64">*115 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 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 remitred1996 Tax Ct. Memo LEXIS 64">*116 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 removed). 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 performed 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, packing, and audit processes with respect to leathers that were substantially1996 Tax Ct. Memo LEXIS 64">*117 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 fronts ²⁷ 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, 1996 Tax Ct. Memo LEXIS 64">*118 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 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 the1996 Tax Ct. Memo LEXIS 64">*119 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 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 experienced1996 Tax Ct. Memo LEXIS 64">*120 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:

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 marketing for B&L Ireland was handled by Bausch & Lomb United Kingdom (B&LUnited Kingdom) in London. The sunglasses assembled by B&L Ireland were sold primarily for distribution in Europe and the Middle East. Most of its European customers were B&L subsidiaries that operated warehouses1996 Tax Ct. Memo LEXIS 64">*122 in most of the European countries. In the Middle East, most of B&L Ireland's customers were independent 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 facility. 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 distribution in Southeast Asia. It sold sunglasses directly to retail optical shops in Hong Kong and sold to both related and independent 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 1996 Tax Ct. Memo LEXIS 64">*123 Hong Kong assembled sunglasses 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 Petitioners did not report any of B&L Hong Kong's income as subpart F income for its 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 of B&L Hong Kong's income as subpart F income for their taxable year ended December 25, 1983, because that company "generated 1996 Tax Ct. Memo LEXIS 64">*124 an overall loss from subpart F operations" for that year.

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 he1996 Tax Ct. Memo LEXIS 64">*125 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 purchased, 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.

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 admissibility.

The bases for most of the objections in the stipulations of facts are that certain stipulated facts and exhibits are inadmissible 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. 1996 Tax Ct. Memo LEXIS 64">*126 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 certain stipulated exhibits on grounds of hearsay. "'Hearsay' is a statement, other than one made by the declarant while testifying 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 Yachting1996 Tax Ct. Memo LEXIS 64">*127 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 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 conversation that he had with another individual concerning the availability of training grants from the IDA for B&L Ireland's contact lens operations. We find that that paragraph constitutes hearsay within1996 Tax Ct. Memo LEXIS 64">*128 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. ³¹Section 954(d) provides 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, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person * * * where--