The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Harvey Poniachek
Medtronic disagreed with the IRS’s use of the comparable profits method (CPM) for 2005 and 2006 audit years, which they argued wasn’t the best method and the results were inconsistent with the arm’s-length standard. The taxpayer filed a law suit in the U.S. Tax Court. On June 9, 2016, the Tax Court issued its decision stating that the IRS’s allocation of income to Medtronic for the intercompany licensing of intangibles was arbitrary, capricious, and unreasonable. The court rejected the IRS application of CPM and endorsed the comparable uncontrolled transaction (CUT) method applied by the taxpayer.
The Commissioner of Internal Revenue (Commissioner or the IRS) appealed the Tax Court’s decision in Medtronic, Inc. v. Comm. for the 2005 and 2006 tax years (Medtronic, Inc. & Consolidated Subsidiaries v. Commissioner, United States Court of Appeals for the Eighth Circuit, August 16, 2018.)
The dispute involves the transfer pricing methodology and the allocation of income between Medtronic and its Puerto Rican subsidiary relating to intercompany licensing of intangible property for the manufacture of medical devices and leads by the subsidiary.
This paper addresses the IRS deficiency notice in the amount of $1.4 billion, Medtronic’s challenge and victory in the tax court, and the overturn in appeals. The case contains significant implications for tax courts, corporations and tax professionals relating to the application of the best transfer pricing method, the need for strict adherence to the regulations and analytical transparency. Tax analysis could now be subject to rigorous replication requirements.
Medtronic US (Medtronic or the parent) is a medical products company of implantable cardiac pulse generators and neurological stimulators (devices), and other medical therapy devices (leads) that were produced under license issued by the parent to Medtronic Puerto Rico. For the 2002 tax year, to resolve the audit and close the case, Medtronic and the IRS entered into a Memorandum of Understanding (Memorandum) in which Medtronic Puerto Rico agreed to pay royalty rates of 44% for devices and 26% for leads on its intercompany sales. The IRS agreed to apply the Memorandum’s royalty rates in future years “as long as there [were] no significant changes in any underlying facts”.
For the 2005 and 2006 tax years, the IRS and Medtronic could not agree on how the Memorandum should apply to Medtronic’s royalty income. The IRS determined that the CPM and not the CUT method was the best method to determine an arm’s-length price for Medtronic’s intercompany licensing agreements for those two years. The IRS’s expert performed economic analysis of the functions performed, assets used and risks assumed by Puerto Rico and Medtronic. The analysis showed that the only function performed by Puerto Rico was finished product manufacturing that required an assembled workforce and routine intangibles that involved de minimus risk. Whereas Medtronic performed most of the functions and bore all the risks related to the functions they performed. The IRS issued a deficiency notice to Medtronic alleging that the licensing of intangibles to its Puerto Rican affiliate wasn’t arm’s-length in 2005 and 2006 and reallocated $1.4 billion in income to the U.S. company for those years.
Medtronic disagreed with the IRS and filed a law suit in United States Tax Court, arguing that the CUT method, not the CPM method, was the best method for determining an arm’s-length price for the intercompany licenses. The Tax Court found several flaws in the IRS transfer pricing analysis, including the fact that it did not attribute sufficient weight to the Puerto Rico subsidiary’s role of ensuring that the products it manufactured were of good quality. The Tax Court rejected both parties’ royalty rate valuations, stating that the Commissioner’s “allocations were arbitrary, capricious, or unreasonable”, because it “downplayed” Medtronic Puerto Rico’s role in ensuring the quality of the devices and leads, it used an incorrect return on assets approach, and it improperly aggregated the transactions, and it ignored the value of licensed intangibles.
The Tax Court decided that Medtronic’s CUT method was the best way to determine an arm’s-length royalty rate for intercompany agreements, and used as a CUT a 1992 license agreement that was a part of a litigation settlement between Medtronic and a third party that included cross-licenses and a lump sum payment. However, the Tax Court made a number of adjustments to the third-party license and derived the arm’s-length royalty rate for the devices at 44% and for the lead at 22%. It issued an order concluding that Medtronic had an income tax deficiency of $26,711,582 in 2005, but it had an income tax overpayment of $12,459,734 in 2006, or a total deficiency of $14,251,848.
The Court of Appeals held that the CUT wasn’t the best method for valuing the intangibles licensed to Puerto Rico because the CUT method didn’t meet the standard of Section 482; and the third-party license arrangement wasn’t comparable to the Medtronic-Puerto Rico royalty transaction due differences in circumstances and risk, and the contents of the intangible basket that was licensed. The Eighth Circuit was unable to determine whether the court “applied the best transfer pricing method for calculating an arm’s-length result or whether it made proper adjustments under its selected method.” Accordingly, it vacated the Tax Court’s order and remanded the case for further consideration by the Tax Court (In Medtronic, Inc. & Consolidated Subsidiaries v. Commissioner, United States Court of Appeals for the Eighth Circuit, August 16, 2018.)
The IRS argued that the Tax Court applied the wrong transfer pricing method and failed to determine the arm’s-length royalty rates, which resulted in a massive shift of income from the U.S. to an offshore subsidiary operating in a tax haven in Puerto Rico. The IRS appealed the Tax Court’s decision to the Eighth Circuit, challenging the Tax Court’s decision.
IRC Regulation Sec 1.482-4 (a) requires that “the arm’s length amount charged in a controlled transfer of intangible property must be applied in accordance with all of the provisions of § 1.482-1, including the best method rule of § 1.482-1(c), the comparability analysis of § 1.482-1(d), and the arm’s length range of § 1.482-1(e)”.
IRC Regulation Dec 1.482-1(c) Best method states that the arm’s length result of a controlled transaction must be determined under the method that provides the most reliable measure of an arm’s length result. There is no strict priority of methods, and no method will invariably be considered to be more reliable than others. An arm’s-length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm’s-length result it must be used. In determining which methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled transaction and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis.
IRC Regulation Sec 1.482-4(c)(1)states that the CUT method evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction. IRC Regulations § 1.482-1(d) Each transfer pricing method requires analysis of all of the factors that affect comparability under that method, including the following -
IRC Regulation Sec 1.482-4(c)(iii) requirements for the CUT are quite stringent. Application of the CUT method requires that the controlled and uncontrolled transactions be the same or comparable intangible property, be used in similar products or processes within the same general industry or market; similarity in contractual terms and circumstances, have similar profit potential, similar duration of the license; any economic and product liability risks to be assumed by the transferee; and the functions to be performed by the transferor and transferee. IRC Regulations § 1.482-1(d). The degree of comparability requires that uncontrolled comparables be derived from the geographic market in which the controlled taxpayer operates, but if obtained from a different geographic market adjustments should be made to account for differences between the two markets.
In using the CUT method, the Tax Court applied the Pacesetter agreement as the best CUT to calculate the arm’s-length result for intangible property. The Court of Appeals concluded that the Tax Court’s factual findings relating to the CUP were insufficient to enable them to conduct an evaluation of that determination. The agreement was entered into by Pacesetter’s parent company and Medtronic US in 1992 to settle several lawsuits regarding patent and license use. As part of the agreement, the parties cross-licensed their pacemaker and patent portfolios and agreed that Medtronic would receive a $75 million lump sum payment plus a 7% royalty for all future sales of cardiac stimulation devices in the United States.
The Pacesetter-Medtronic US agreement was not a comparable uncontrolled transaction, and the Tax Court did not sufficiently address (1) the lump sum payment that was a part of it; (2) the cross-licenses that were a part of it; and (3) certain intangibles that were not part of it.
The Pacesetter-Medtronic agreement contained a $75 million lump-sum payment whereas the Medtronic US-Medtronic Puerto Rico agreement was a royalty-only one. The Tax Court failed to address this difference. Courts have held that agreements which include cross licenses are inadequate comparisons for “hypothetical negotiation[s]”—damage assessments—where they are not involved. That sometimes the “most reliable license” for comparison may “ar[i]se out of litigation,” but the “unpredictability of patent litigation remains notorious” and that “particular litigation settlements may be based on unique considerations”.
The Tax Court did not address whether the circumstances of the settlement between Pacesetter and Medtronic US were comparable to the licensing agreement between Medtronic and Medtronic Puerto Rico. The Pacesetter agreement resolved litigation between the parties, and the Tax Court did not decide whether it was one created in the ordinary course of business.
The Pacesetter agreement was limited to patents and excluded all other intangibles, including “any technical know-how or design information, manufacturing, marketing, and/or processing information or know-how, designs, drawings, specifications, software source code or other documents directly or indirectly pertinent to the use of the Licensed patents.” The Medtronic Puerto Rico licensing agreement, on the other hand, did not exclude such intangibles. Although the Tax Court made a 7% adjustment for the “know how” that Medtronic Puerto Rico received from Medtronic, as well as a 2.5% adjustment to account for the differences in licensed products (the Pacesetter agreement licensed only cardiac “patent portfolios” whereas Medtronic’s agreements also licensed neurological products), the Appeals Court cannot determine the appropriateness of using the Pacesetter agreement as a CUT without additional findings regarding the comparability of the remaining intangibles.
In the absence of findings regarding the degree of comparability between the controlled and uncontrolled transactions, the Appeals Court could not determine whether the Pacesetter agreement constituted an appropriate CUT.
Finally, the Tax Court did not decide the amount of risk and product liability expense that should be allocated between Medtronic US and Medtronic Puerto Rico. The Commissioner contends that Medtronic Puerto Rico bore only 11% of the devices and leads manufacturing costs, and therefore Medtronic Puerto Rico’s allocation of profits should be a similar percentage based on its economic contribution. The Tax Court rejected the Commissioner’s 11% valuation, concluding that it was unreasonably low because it did not give enough weight to the risks that Medtronic Puerto Rico incurred in its effort to ensure quality product manufacturing. Yet the Tax Court reached these conclusions without making a specific finding as to what amount of risk and product liability expense was properly attributable to Medtronic Puerto Rico. In the absence of such a finding, the Court of Appeals lacks sufficient information to determine whether the Tax Court’s profit allocation was appropriate.
Accordingly, the Tax Court allocated almost 50% of the device profits to Medtronic Puerto Rico. In doing so, it rejected the Commissioner’s comparable profits methods because it found that the comparable companies used by the Commissioner under this method did not incur the same amount of risk incurred by Medtronic Puerto Rico.
The Court of Appeals rejected the Tax Court’s determination that the Pacesetter agreement was a CUT and noted that the Tax Court didn’t apply the best transfer pricing method for calculating an arm’s-length result and failed to make proper adjustments under its chosen method. The Eighth Circuit held that the Tax Court had adopted the transfer pricing method of the taxpayer without first engaging in the analysis required under Treasury’s transfer-pricing regulations. Accordingly, the Court of Appeals vacated the Tax Court’s January 25, 2017, order and remanded the case for further consideration in light of the views set forth in this opinion.
The Court of Appeals for the Eighth Circuit issued an opinion August 16, 2018, reversing the Tax Court decision. The Eighth Circuit remanded the case back because the Tax Court’s factual findings were insufficient to conduct an evaluation of the determination.
The Court of Appeals has sent a sound message to tax courts, the IRS, corporations and tax practitioners that thorough adherence to tax regulations is necessary, applications of the tax code needs to be transparent and the economic analysis need to be supported by facts and subject to replication. Going forward, taxpayers and the IRS are likely to follow the tax regulations more rigorously rather than apply shortcuts for the sake of closing audits more rapidly.
The rollover of past agreements between the IRS and taxpayers into open taxable years was always subject to whether the facts and circumstances remained the same as in the years for which the agreement was drafted. It seems that the applicability of prior settlements between taxpayers and the government to open years might have suffered severely in this case. Reduced ability to apply old agreements to issues going forward could prolong the time and diminish the productivity of the parties involved, and, in many respects, perhaps undermine the work of the APA or similar programs.
The Medtronic case provides several technical pitfalls relating to the selection of the best method, and the merit of the comparables, and whether the CUTs or income based methods are preferable. However, the Tax Court made several adjustments to the CUT that were neither clearly explained, nor were they based on solid regulatory, or economic arguments that could be replicated, thus raising serious questions about the merit of the CUT method. (See Harvey Poniachek, Medtronic Revisited: Outcome Under the OECD’s BEPS Recommendations, BNA Tax Management, Transfer Pricing Report, Vol. 25, No. 22, March 23, 2017.)
Harvey Poniachek, Ph.D., CVA (Harvey.email@example.com) is on the faculty of Rutgers Business School finance and economics department, and was formerly lead economist at U.S. Treasury Department, where he specialized in transfer pricing and valuation Issues. A version of this article was presented at the Stamford Tax Association on Sept 27, 2018.
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