Taxpayers are free to structure their intercompany transactions as they wish if the intercompany pricing is consistent with the arm’s length standard. Any evaluation of a transfer pricing issue depends on what the fundamental question is. In my view, the IRS lost Altera because it was asking the wrong question. In this blog, we will not discuss the issue of employee stock options, but rather one of the strange reactions to the Court’s decision. Does the arm’s-length principle require an analysis must look to third-party transactions to arrive at a price for a related-party transaction?
Elizabeth King posed this question in terms of intangible assets that are seen as the “crown jewels” noting a debate between advocates of the commensurate-with-income standard as opposed to analysts who prefer to do evaluations in terms of third party licenses of intangible assets. We noted in our previous blog discussion how such limited thinking on the issue of what is a reasonable royalty rate can lead to two extremely different views with neither consistent with the particular facts or good economics.
Let’s explore this by considering a hypothetical situation. Gilead’s Irish affiliate recently purchased the phase II rights from Pharmasett for treatments known as Sovaldi and Havroni. These innovative treatments for Hepatitis C are generating profit margins near 90 percent of sales given their price per pill versus the very modest cost of production and distribution. While the transfer pricing structure is for the Irish affiliate to use third party contract manufacturers to produce the pills and then sell the products to distribution affiliates, suppose another firm decides to violate their patents and produce and distribute the same products. Clearly Gilead would have the right to sue and seek damages based on a reasonable royalty, which is akin to the arm’s length royalty rate.
We can imagine that the defense attorneys hired an expert witness to argue for a reasonable royalty rate no greater than 40 percent as very few third party royalty rates in the biopharma sector exceed 40 percent. But is this application of the Comparable Uncontrolled Transaction approach reasonable given no other treatment has had the profit potential of Sovaldi and Havroni? Gilead would certainly find an economist who could use a reasonable analytical approach to demonstrate a much higher arm’s length royalty rate.
In the context of transfer pricing, the analytical approach is often used when the Comparable Uncontrolled Transaction approach does not lead to reliable results. We noted in our previous blog post the Medtronic litigation. Whereas the IRS has rejected the taxpayer’s application of the Comparable Uncontrolled Transaction approach to argue for a very low royalty rate, we also noted that the IRS’s use of the Comparable Profits Method ignored potential reasons for the licensee to retain a portion of the residual profits. This Medtronic litigation is replaying the Bausch & Lomb litigation in many ways. In that litigation, the taxpayer argued that its 5 percent royalty rate was consistent with royalty rates in similar third party transactions. While the Court rejected this position, it also rejected the IRS position that the royalty rate should exceed 50 percent based on an application of its interpretation of the commensurate-with-income standard. The Court posited an interesting analytical approach to show that a reasonable royalty rate should be 20 percent.
Some of the reactions to the Altera decision are over the top as this decision was essentially the same decision in Xilinx. The Court responded to the question that was posed to it as well as the evidence that was presented. In many ways, the IRS let the question be posed in an odd way and then failed to respond to the evidence that the taxpayer presented. Attempting to draw broad lessons from the specific issue before the Court is not warranted.