U.S. Tax Court Renders Split-Decision in Medtronic Case
On August 18, the U.S. Tax Court issued its second opinion in the long-running transfer pricing dispute between Medtronic and the Internal Revenue Service (IRS) over the arm's length royalty owed under intercompany licenses between the U.S. parent of the Medtronic consolidated group (Medtronic US) and its Puerto Rican affiliate (MPROC). This time around the court held that the third-party agreement put forward by Medtronic (the Pacesetter agreement) is not sufficiently comparable and that the comparable uncontrolled transaction (CUT) method is not the best method for pricing the controlled transactions. See Medtronic, Inc. & Consol. Subsidiaries v. Commissioner, T.C. Memo. 2022-84. This represents a reversal in the approach the court had taken in its 2016 opinion (Medtronic I), where it held that the CUT method was the best method and made several adjustments to the Pacesetter agreement to arrive at a wholesale royalty rate of 44 percent for devices and 22 percent for leads manufactured by MPROC. See T.C. Memo. 2016-112, vacated and remanded, 900 F.3d 610 (8th Cir. 2018). On remand from the Eighth Circuit Court of Appeals, which called into question the factual basis for the comparability of the Pacesetter agreement, the Tax Court adopted an unspecified method to determine a wholesale royalty rate under the Medtronic US-MPROC licenses of 48.8 percent for both devices and leads, resulting in an overall profit split of roughly 69 percent to Medtronic U.S. affiliates and 31 percent to MPROC (compared to an overall Medtronic U.S. affiliates-MPROC profit split of roughly 54-46 percent in Medtronic I and 93-7 percent under the IRS's original position).1
The Tax Court Again Concludes that the CPM is Not the Best Method
The recent Medtronic opinion follows the Eighth Circuit's 2018 opinion concluding that the Tax Court's factual findings in Medtronic I were insufficient to enable the appellate court to evaluate the Tax Court's determination that the Pacesetter agreement was an appropriate CUT. See 900 F.3d at 614. In the remand proceedings, the IRS maintained its position from Medtronic I that the comparable profits method (CPM) with MPROC as the tested party was the best method to price the intercompany licenses. In an effort to address the Tax Court's critique of the IRS methodology, the IRS put forward a "modified CPM," which limited the original 14 comparable companies to five companies that manufactured implantable products.2 See T.C. Memo. 2022-84, at 42-43.
The Tax Court again rejected the IRS's CPM as the best method, concluding that the IRS methodology, despite changes proposed in the modified CPM, suffered the same problems the court had identified in Medtronic I. The fundamental flaw in the CPM was the lack of comparability between MPROC and the companies the IRS selected as comparables. Unlike MPROC, which manufactured only class III medical devices, the IRS comparables manufactured a range of products, including class I and class II devices, none of which was similar to the devices MPROC manufactured, and performed other functions not performed by MPROC (e.g., research and development (R&D) and distribution). As such, the Tax Court concluded that the IRS's proposed CPM fell short. See id. at 44-47.
Too Many Adjustments Led to Reconsideration of CUT Method
Following the Eighth Circuit's directive, the Tax Court reconsidered whether the Pacesetter agreement is an appropriate CUT, ultimately concluding that it is not. As a refresher, in the 1990s Medtronic US and Pacesetter entered into a cross-license of each party's patent portfolios relating to their cardiac rhythm disease management businesses in the context of settling patent litigation between the parties. See T.C. Memo. 2022-84, at 17-18. Despite finding that the Pacesetter agreement was entered into in the ordinary course of business and that "there is a level of comparability [in contractual terms] between the Pacesetter agreement and the MPROC licenses," see id. at 33-37, the Tax Court held that the Pacesetter agreement is not a CUT.
Taking a fresh look at the general comparability factors in Treas. Reg. § 1.482-1(d)(1), the court found that the Pacesetter agreement failed the comparability test based on three of the factors:
- Functional differences between Pacesetter and MPROC, with the latter engaged solely in the manufacture of finished products while Pacesetter also performed other functions such as R&D and distribution
- Differences in the profit potential of products manufactured by MPROC and Pacesetter products
- Differences in the intangible property licensed to MPROC and that licensed to Pacesetter (see id. at 29-32)
A significant hurdle the court could not overcome this time around was the extent of adjustments necessary to make the Pacesetter agreement a CUT. The court reassessed the adjustments it made in Medtronic I, concluding that "too many adjustments result in the Pacesetter agreement as a CUT not being the best method pursuant to the section 482 regulations." Id. at 33.
The Tax Court also addressed the court's opinion in The Coca-Cola Co. & Subsidiaries v. Commissioner, issued in the intervening period between the Eighth Circuit's Medtronic opinion and the second Tax Court Medtronic opinion. See 155 T.C. 145 (2020). The IRS sought to draw analogies between Medtronic and Coca-Cola where the Tax Court held that the CPM was the best method to price intercompany licenses between the U.S. licensor and foreign affiliates that the court found were entitled to compensation for routine manufacturing activities. The court was unpersuaded by the IRS's efforts, concluding that the facts in Coca-Cola were not comparable to those in the present case. See T.C. Memo. 2022-84, at 38, 60.
An Unspecified Method Carries the Day
Having rejected both the CPM and the CUT method as best methods to price the MPROC licenses, the court turned to a new, unspecified method that incorporates both methods. Given the court's inquiry during remand proceedings, Medtronic proposed, as an alternative to its primary position, a three-step unspecified method that combined aspects of the CPM and the CUT method. At a high level, the first two steps in Medtronic's unspecified method allocated profit to the activities of Medtronic U.S. affiliates (such as R&D and distribution) and to MPROC's manufacturing activities, respectively, primarily by applying a modified version of Medtronic's CUT method and a modified version of the IRS's CPM. As a last step, Medtronic allocated the remaining system profit between Medtronic US and MPROC "using commercial and economic evidence." T.C. Memo. 2022-84, at 53. The court largely adopted Medtronic's unspecified method, adjusting only the third step. Instead of allocating remaining profits between MPROC and Medtronic US based on Medtronic's proposed allocations of 65/35 or 50/50, the court made a greater allocation of remaining profits to Medtronic US based on an 80/20 Medtronic US-MPROC split. See id. at 66-67.
We've been following Medtronic closely since the early stages of the dispute given its significance in the transfer pricing space. The Eighth Circuit's opinion vacating Medtronic I and remanding the case to the Tax Court for further proceedings was an important development in this area, raising critical considerations relevant to taxpayers' use of CUTs to support their transfer pricing practices. The latest Tax Court Medtronic opinion confirms that we should expect heightened scrutiny by the IRS and the courts on transactional methods such as CUTs. This may be particularly the case when, as in Medtronic, many adjustments are necessary to arrive at an arm's length result, which may bring into question the reliability of the results under the transactional method.
The Tax Court's endorsement of an unspecified method to benchmark the MPROC royalties is novel. Dissatisfied with the CPM and the CUT method proposed by the parties, the court settled on an unspecified method to "bridge the gap" between the CPM and the CUT method and address the key flaws it perceived in those other methods. That unspecified method allocates returns to the licensor and licensee based on the CUT method and the CPM, respectively, splitting remaining system profits on an 80/20 basis. Resorting to an unspecified method of this type to price transfers of intangibles is unusual in recent experience, and in some ways recalls the rough profit splits or rules of thumb courts employed prior to changes to section 482 and the regulations thereunder decades ago. This approach is somewhat surprising given the detailed regulations setting forth profit split methods, which may have been employed by the court to reach somewhat similar results under the imprimatur of a method specified by the regulations. Ultimately, the opinion demonstrates the significant discretion courts can have in determining a middle ground in transfer pricing cases where the court is dissatisfied with the position of both parties. Query whether the latest Medtronic opinion signals the beginning of a new approach, or whether the Tax Court's analysis will be limited to the unique factual circumstances in the case.
While this may not be the final phase of the Medtronic dispute if there is an appeal to the Eighth Circuit, the latest Tax Court opinion may influence developments in other pending transfer pricing litigation, as well as the resolution of transfer pricing controversies in the Examination process or at Appeals.
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1 Also at issue in the case is an agreement between Medtronic US, MPROC, and a European affiliate (the Swiss Supply Agreement) under which the European affiliate agreed to use its manufacturing operations to assist MPROC by manufacturing and supplying devices when necessary to meet excess demand. Consistent with Medtronic I, the court concluded that the royalties payable by the European affiliate to Medtronic US under the Swiss Supply Agreement should be computed using the same rate the court determined for royalties payable by MPROC for devices (48.8 percent). See T.C. Memo. 2022-84, at 72.
2 The IRS's modified CPM also made an adjustment for product liability, assuming, arguendo, that MPROC bore all product liability risk. See T.C. Memo. 2022-84, at 43.
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