In Brief
Medtronic Inc. & Consolidated Subsidiaries v. Commissioner (T.C. Memo. 2016-112) is the latest defeat for the U.S. Internal Revenue Service ("IRS") in a string of transfer pricing losses. The IRS sought to increase royalties payable from a Puerto Rico affiliate to Medtronic, Inc. ("Medtronic US" or "Taxpayer") by $US1.4 billion. The Tax Court rejected the IRS's proposed transfer pricing method as arbitrary, capricious, and unreasonable. The court instead accepted Medtronic US's chosen transfer pricing method, albeit with some adjustments.
Background
Medtronic US and its affiliates develop and sell medical devices
all over the world. Medtronic US, the U.S. parent of the Medtronic
group during the years at issue, indirectly owned a Puerto Rican
manufacturing entity (Medtronic Puerto Rico Operations Co,
"Medtronic PR"). Principally at issue in this case were
the royalties paid by Medtronic PR to Medtronic US for the use of
certain intangibles in Medtronic PR's manufacture of highly
regulated, class III medical devices ("Devices").
Medtronic PR was an FDA-regulated manufacturer responsible for,
inter alia, testing, sterilizing, and quality control with
respect to the finished Devices it manufactured. Medtronic PR
employed engineers and other highly trained personnel, as the
manufacturing process was complex—sometimes taking seven to
14 days to complete a single Device. Further, some processes could
not be done automatically and required skilled workers to complete
them by hand. Medtronic PR bore material market risk and focused
intently on quality because the finished Devices were implanted in
human patients. Defects meant possible deaths.
For the 2005 and 2006 tax years, Medtronic PR paid royalties to
Medtronic US pursuant to certain licenses ("Licenses")
for the use of the intellectual property necessary to manufacture
the Devices. Medtronic had determined the arm's-length royalty
rates for the Licenses using the comparable uncontrolled
transaction ("CUT") method. The IRS took the position
that the Taxpayer should have instead used the comparable profits
method ("CPM"). The IRS determined that Medtronic
PR's profits were in excess of an arm's-length return and,
accordingly, made significant upward adjustments to the royalties
payable to Medtronic US under the Licenses.
The IRS had audited the same intercompany transactions for the 2002
tax year, similarly finding that the royalty rates were too low.
The parties had settled this audit by executing an informal
memorandum of understanding ("2002 MOU") pursuant to
which Medtronic US agreed to use prescribed (higher) royalty rates
and system profits allocations. For 2005 and 2006, however, the IRS
asserted that the royalties were again too
low—notwithstanding that they comported with the MOU.
The Court's Holding
The IRS had concluded that: (i) Medtronic PR performed functions
less complex that those performed by Medtronic US and could have
been replaced by an unrelated contract manufacturer, and (ii)
Medtronic PR's contributions did not rise to the level of
non-routine intangibles (which could have justified greater value
being allocated to Medtronic PR). The IRS's expert used a CPM
to determine the value of Medtronic PR's "routine"
contribution and assigned the remaining system profit to the U.S.
operations. He then computed appropriate royalty rates to achieve
that result.
The court took issue with this analysis. The IRS expert had
dismissed the importance of quality control and artificially
reduced Medtronic PR's role to the mere assembly of components.
In addition, the court raised technical concerns with the IRS's
choice of comparables, profit level indicators, and the fact that
multiple independent, intercompany transactions were unnecessarily
aggregated for purposes of the analysis. (That is, once the expert
determined a return for Medtronic PR, he assigned all remaining
profit to Medtronic's US operations, without determining
arm's-length returns for the various intercompany
transactions.) This approach resulted in an unreasonably small
allocation of profits to Medtronic PR. Accordingly, the court
rejected the IRS's adjustments as arbitrary, capricious, and
unreasonable.
The court accepted the Taxpayer's CUT method but made
adjustments to account for certain differences between the Licenses
and the comparable transaction relied on by the Taxpayer (a license
between Medtronic US and a third party for some of the same
patents). Thus, although the court agreed that the CUT method was
the best method under the circumstances, it made corrective
adjustments to arrive at its own royalty rates—which were
lower than the rates the IRS had sought but higher than those
asserted by the Taxpayer.
Implications
Given the fact intensity of this case, as with most transfer pricing cases, drawing broad conclusions is difficult. That said, there are a few insights to be gleaned from the court's lengthy ruling. Perhaps most notable is simply the court's continued willingness to reject IRS allocations in the transfer pricing context, notwithstanding the high bar of "arbitrary, capricious, and unreasonable." This is welcome news for practitioners and taxpayers, given that aggressive transfer pricing audits seem to be on the uptick. Also well received is the court's disinclination to follow the IRS's perceived preference for aggregating transactions and for using profit-based methods for intangible property transfers. Finally, even though the facts will inevitably differ from case to case, this opinion could provide additional ammunition to taxpayers seeking to allocate more income to offshore contract manufacturers, on the grounds that they have a highly skilled workforce and perform important quality control functions.
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