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June 9 — The IRS grossly underrated the contributions of Medtronic Inc.'s Puerto Rican affiliate to the quality of the company's products, the U.S. Tax Court ruled, finding for the medical device maker in its $2 billion transfer pricing dispute ( Medtronic, Inc. v. Commissioner , T.C., No. 6944-11, T.C. Memo. 2016-112, 6/9/16 ).
In a memorandum opinion June 9, Judge Kathleen Kerrigan found that the Internal Revenue Service's economic expert had committed fatal errors in his analysis of the interplay between the U.S. parent and its Puerto Rican subsidiary.
She rejected the agency's argument that a comparable-profits method was the best method for analyzing the intercompany pricing. Rather, she found that Medtronic properly applied a comparable uncontrolled transactions (CUT) method to most of the transactions at issue in the case.
The disputes involve four intercompany agreements, including licensing of manufacturing intangibles for the production of medical devices and leads, a trademark license agreement, a components supply agreement, and a distribution agreement.
Kerrigan adjusted the calculation of royalties for the devices from the 29 percent proposed by Medtronic to 44 percent, and adjusted royalties for the leads from 15 percent to 22 percent.
What impact her ruling will have on the IRS's proposed income allocation for Medtronic will be determined later.
At the heart of the dispute is whether Medtronic Puerto Rico Operations Co. (MPROC) is an entrepreneurial and autonomous manufacturer of medical devices, as the company argued, or whether, as the IRS maintained, its operations are mere assembly plants, playing only a minor role in a long process of design, development, and manufacture carried out by the U.S. parent.
Kerrigan found the company's arguments more persuasive. The IRS, she said, was too dismissive of MPROC's contributions to the profits of the entire enterprise and failed to account for the importance of quality in the medical device industry.
In court filings and oral arguments, the IRS maintained that MPROC posted “outsize profits” in tax years 2005 and 2006, leading to “absurd results”—returns on assets of 211 percent and 301 percent, respectively.
Such returns rendered MPROC “vastly more profitable than Medtronic as a whole, than any of Medtronic's competitors, and almost any company in the medical device industry,” the agency said in a pre-trial brief. “Such results cannot withstand scrutiny under the arm's length standard of section 482” (248 DTR K-7, 12/29/14).
This analysis, however, was premised on erroneous assumptions about MPROC's activities, Kerrigan said. Though the IRS treated MPROC as a mere assembly operation, the company “did more than assemble components.”
MPROC operated facilities that were registered with the U.S. Food and Drug Administration, Kerrigan said, and it manufactured Class 3 medical devices for treatment of cardiac and neurological conditions and employed 2,300 workers in three locations. Its employees, Kerrigan noted, included engineers who worked on product development.
“MPROC had the responsibility of taking all the third-party suppliers’ components and incorporating them into class III medical devices,” she said. “MPROC uses its systems engineering expertise to design improvements and improve quality. MPROC has a highly skilled workforce. MPROC tests and sterilizes the devices and leads.”
All these activities, she said, were critical to the quality of the products.
“It is difficult to place an exact value on what MPROC contributed to the manufacturing of devices and leads, but it is certainly more” than the value attributed by the IRS's economic expert, Kerrigan said.
The IRS based its notice of deficiency and its arguments at trial on an analysis made by economist A. Michael Heimert, who used a comparable-profits method to conclude that too much value had been shifted from the U.S. parent to the Puerto Rican affiliate.
Heimert concluded that only 6 percent to 8 percent of the system profits should be allocated to MPROC, but this conclusion shifts too much profit to Medtronic U.S., Kerrigan said.
“Heimert’s analysis was based on his findings that MPROC performed one important function—finished manufacturing—among many important functions within the highly integrated value chain,” Kerrigan said. “This approach treated MPROC as equivalent to many other third-party medical device manufacturers who do not create nonroutine assets and who do not bear additional risks that would require the assignment of additional profits.”
Heimert also erred, she said, in his choice of comparables and in calculating return on assets. By looking only at the value of the buildings, equipment, and inventory, Heimert did not consider the valuable intangible assets that were obtained through the devices and leads licenses, she said.
But Kerrigan also criticized the taxpayer's analysis, finding that the royalty rates Medtronic proposed for the devices and leads licenses were not arm's length because, in addition to other errors, the company didn't make appropriate adjustments to its CUT method to account for variations in profit potential.
“We do not agree with respondent that his approach is the best method and that adjustments could not be made to the one troubling area of petitioner’s methodology—the royalty rates for the licensing of intangibles for devices and leads. We conclude that appropriate adjustments should be made to petitioner’s CUT.”
Kerrigan also rejected the IRS's alternative argument that intangible property subject to tax code Section 367(d) must have been transferred to MPROC in 2002 when it was formed. The argument is based on the premise that MPROC couldn't possibly be profitable unless intangibles had been transferred to it.
“We are not persuaded by this argument,” she said.
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Text of the decision is in TaxCore.
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