Medical device manufacturer, Medtronic, began its second trial on June 14 in the US Tax Court in a $1.36 billion transfer pricing dispute with the IRS. The trial concluded on June 25 and is among the most significant transfer pricing disputes with the IRS, presenting a battle of the correct transfer pricing method to impose tax upon multinational companies to place “a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.” Treas. Reg. § 1.482-1(a)(1). The Medtronic case highlights the dual burden faced by a taxpayer in a transfer pricing case, where a taxpayer must first convince a court to reject the IRS’s transfer pricing method as an abuse of discretion, and then show that the taxpayer’s method led to a proper arm’s-length result. The case also highlights the significant discretion a court may have in devising its own transfer pricing method, which is what can happen if the court finds that the taxpayer has met the first part of its dual burden but not the second.
Background
The Medtronic case is rooted in the dispute over the company’s allocation of profits for tax purposes between Medtronic and its Puerto Rican affiliate. Medtronic US (parent) and its distributor, Medtronic USA, Inc., are located in the United States, and Medtronic Puerto Rico Operations Co. (Medtronic Puerto Rico) is located in Puerto Rico. Medtronic Puerto Rico licenses from Medtronic US intangibles are necessary for the manufacture and sale of certain medical devices. Medtronic selected the Comparable Uncontrolled Transaction (CUT) method, applied on the basis of Medtronic’s 1992 patent litigation settlement agreement with Siemens Pacesetter, Inc. (the Pacesetter Agreement), as the best method to determine the arm’s-length royalty rate for the licensing of intangible property. The CUT method looks to an agreement involving unrelated parties as a benchmark for pricing the transfers within a multinational company. Using the Pacesetter Agreement as a benchmark, Medtronic relied on royalty rates as agreed upon with the IRS in a Memorandum of Understanding (Memorandum) during the close of the 2002 tax year audit. 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.” However, during the 2005 and 2006 audit, the IRS determined that the Comparable Profits Method (CPM) was the best method for the intercompany licensing arrangement arguing that the relatively routine functions of the Puerto Rican subsidiary and the lack of comparability between the Pacesetter Agreement and Medtronic’s intercompany license made the CPM the more reliable method. The IRS argued that the Puerto Rican subsidiary performed “less complex functions” than Medtronic, and accordingly, arm’s-length royalty rates for intercompany licenses should be priced using CPM, which takes into account profits from similar companies. Under this method, the IRS argued that Medtronic’s US entities should have received 90% of the income from the licensing transaction, which results in an overall adjustment of $1.36 billion for the 2005-2006 tax years.
The first trial
In the first trial, the Tax Court found that Medtronic had satisfied its burden of proving, by clear and convincing evidence, that the IRS’s proposed transfer pricing method – the CPM method – was “arbitrary, capricious, and unreasonable.” The Tax Court concluded that the Puerto Rican subsidiary did more than just assemble parts for the parent company’s cardiac and neurological product lines and determined that the CUT method was the best transfer pricing method. However, the Tax Court disagreed with the application of the CUT method by Medtronic, and engaged in its own analysis. Though the Tax Court agreed with Medtronic that the Pacesetter Agreement was comparable to the intercompany technology licensing agreement between Medtronic and Medtronic Puerto Rico, the Tax Court made adjustments that were intended to account for the broader set of intangibles covered by Medtronic’s intercompany technology license than were covered by the Pacesetter Agreement, which only licensed patent rights. The Tax Court’s determination resulted in a revised tax deficiency of $14 million.
In 2018, however, the US Court of Appeals for the Eighth Circuit (Medtronic, Inc. v. Comm’r, 900 F.3d 610 (8th Cir. 2018)) vacated and remanded the case, ordering the Tax Court to make several additional findings to justify more extensively the transfer pricing method it said Medtronic could use. The Eighth Circuit found that the Tax Court’s findings were insufficient to support its use of the Pacesetter Agreement as a comparable transaction. The Eighth Circuit had several issues with the Tax Court’s findings. First, the Eighth Circuit determined that the Tax Court did not address in sufficient detail 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 created in the ordinary course of business. Further, the Eighth Circuit found that the Tax Court did not analyze the degree of comparability of the Pacesetter Agreement’s contractual terms and those of the Medtronic Puerto Rico licensing agreement. For example, the Tax Court acknowledged that the Pacesetter Agreement included a lump sum payment and a cross-license, but it did not address how Pacesetter’s additional terms affected the degree of comparability with Medtronic Puerto Rico’s licensing agreement, which did not include a lump sum payment or cross-license. The Tax Court also did not evaluate how the different treatment of intangibles affected the comparability of the Pacesetter Agreement and the Medtronic Puerto Rico licensing agreement. The Pacesetter Agreement was limited to patents and excluded all other intangibles. Finally, the Tax Court allocated almost 50% of the device profits to Medtronic Puerto Rico without a specific finding as to the amount of risk and product liability expense that was properly attributable to Medtronic Puerto Rico.
The second trial
The trial on remand focused on additional findings requested by the Eighth Circuit concerning the appropriateness of the Pacesetter Agreement in applying the CUT method. Despite the findings of the first trial, the IRS continued to maintain that the CPM is more reliable, arguing that the royalty should be calculated by subtracting Medtronic Puerto Rico’s arm’s-length return on assets from its total profit and dividing that amount by the entity’s revenues. Medtronic continued to argue that the CUT method, applied on the basis of the Pacesetter Agreement, is the best method to determine the arm’s-length royalty for the Medtronic Puerto Rico license. At the close of the trial, the Tax Court remarked that it was “in the unusual situation where I get to Monday-morning quarterback myself, and I think I would make some changes to my previous adjustments to the CUT.” Further, in light of the adjustments to the CUT method under consideration, the Tax Court indicated that the method may no longer be a proper application of the CUT method as set out in Treas. Reg. section 1.482-4(c). The Tax Court indicated that it may be looking to the unspecified method of Treas. Reg. section 1.482-4(d), which may combine aspects of each party’s preferred method, or even average the results of applying the two.
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Eversheds Sutherland Observations: Section 482’s transfer pricing provisions grant the IRS broad discretion to “distribute, apportion, or allocate gross income, deductions, credits, or allowances” between or among controlled enterprises if it determines that such a re-allocation is “necessary in order to prevent evasion of taxes or clearly to reflect the income” of any of the enterprises. The IRS’s section 482 determination must be sustained absent a showing of abuse of discretion. Accordingly, whether the IRS abused its discretion is a question of fact that is resolved on the basis of the trial record. A taxpayer that challenges a Section 482 adjustment therefore has a “dual burden,” which the history of the Medtronic case brings sharply into focus. First, the taxpayer must show by clear and convincing evidence that any IRS proposed transfer pricing adjustment is “arbitrary, capricious, unreasonable amounting to an abuse of discretion.” Second, the taxpayer must show by a preponderance of evidence (greater than 50% probability) the proper arm’s-length result. When a taxpayer meets the threshold burden of proof, the court nevertheless has the authority to determine the arm’s-length result independently if the court determines that neither side is correct as to the proper arm’s-length result. This authority can place significant discretion in the hands of the court regarding the selection and application of the appropriate transfer pricing method, which is what happened here.
In the second Medtronic trial, the Tax Court has an added challenge as the “Monday-morning quarterback” for itself in showing that it undertook an intensive review of the comparables and adjustments used in the taxpayer’s CUT method. Although the Tax Court indicated that it was not interested in hearing the same testimony as it heard last time, Medtronic still needed to establish that the CUT method is reliable and prove that the Pacesetter Agreement was an appropriate comparable. An interesting aspect at the close of the second trial is that the Tax Court suggested the possibility that neither method advanced by the parties may carry the day where there are a number of adjustments to a particular transfer pricing method. Other transfer pricing cases also illustrate that the Tax Court is likely to look at these types of methods more closely, requiring taxpayers to invariably invest more effort defending the use of a transactional comparable. Taxpayers seeking to litigate transfer pricing cases can therefore take a number of lessons from the Medtronic case, which spotlights the taxpayer’s dual burden in these cases, as well as the substantial authority vested in the trial court to make the appropriate determination if neither side is correct as to the proper arm’s-length result.
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