Why Did the Appeals Court Vacate the Medtronic Decision?

The Eight Circuit Court of Appeals vacated the June 9, 2016 trial court decision in Medtronic v. Comr. remanding this intercompany litigation “for further consideration in light of the views set forth in this opinion”. The Appeals Court was critical of the use of the Comparable Uncontrolled Transaction (CUT) approach noting several comparability differences between the controlled transaction and the Pacesetter agreement, which the trial court failed to address in its ruling. Given the fact that the trial court ruled that the intercompany royalty rate should be 30 percent of end user sales whereas the Pacesetter agreement stipulated a royalty rate of only 7 percent, one might speculate how much weight the trial court placed on this alleged CUT.

Another read of the trial court decision is that the judge implicitly arrived at the 30 percent rate by some implicit application of the Residual Profit Split Method (RPSM). The Appeals Court, however, calls for a more explicit application even as it entertains the licensee risk taking critique of the IRS application of the Comparable Profits Method (CPM):

“…tax court also 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. 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, we lack sufficient information to determine whether the tax court’s profit allocation was appropriate.”

We explore one possible application of RPSM in light of my discussion of profits based approaches to multinational whose fact pattern mirrors the fact pattern in the Medtronic litigation.[1] Table 1 presents a multinational with four entities:

• A U.S. distributor (USD) with sales = $6 billion and selling costs = $1.6 billion;
• A U.S. components manufacturer (USM) with production costs = $400 million;
• A Puerto Rican (PR) assembly affiliate (PR) with labor costs = $400 million; and
• The U.S. parent that collects intercompany royalties from the Puerto Rican affiliate for the use of product and marketing intangibles.

Table 1: Medical Device Multinational Example

We present three intercompany (I/C) prices that reflects the IRS CPM approach. Each of the three operating entities receives a 25 percent markup over its operating costs in our illustration.

USM sells components to the Puerto Rican licensee at an intercompany price (I/C price 1) equal to $500 million thereby retaining a routine profit equal to $100 million OP-man). USD purchases finished goods from the Puerto Rican licensee paying it an intercompany price (I/C price 2) equal to $4 billion retaining gross profits equal to $2 billion and operating profits (OP-dis) equal to $400 million. The Puerto Rican assembly retains operating profits before royalties (OPB4Royalty) equal to $3.1 billion.

A third CPM analysis establishes the routine return for assembly to be $100 million (OP-PR) with residual profits being $3 billion. The IRS position is that the royalty rate should be set at 50 percent of sales so the IRS parent captures 100 percent of residual profits.

Total routine returns = $600 million or 10 percent of sales. As such, residual profits represent 50 percent of sales or $3 billion. The IRS position is that the intercompany royalty rate should be the entirety of residual profits on the grounds that the U.S. parent owns all valuable intangible assets. Table 2 presents the implications of this intercompany royalty rate as well as three other scenarios for the percent of profits allocated the Puerto Rican entity as well as the percent of residual profits allocated to the Puerto Rican entity. Note that under the IRS theory, the Puerto Rican entity retains only 3.33 percent of total profits as it would be limited to its routine return.

Table 2: Alternative Royalty Rates and Implication for the Split of Residual Profits

The Appeals decision noted an earlier agreement with an IRS Examination team:

“Using the residual profit split transfer pricing method, the IRS concluded that 90% of Medtronic’s devices and leads profit should be allocated to the United States operations and 10% to the Medtronic Puerto Rico operations…Neither party considered the Memorandum’s royalty rates to be an arm’s length price, but rather as only a compromise in an effort to resolve the audit.”

Table 2 illustrates this compromise as an intercompany royalty rate equal to 46.67 percent, which would leave the Puerto Rican affiliate with 10 percent of total profits but only 6.67 percent of residual profits. Note that the licensee’s share of total profits differs from its share of residual profits. The taxpayer position is that the licensee deserves a share of residual profits for bearing licensee risk. It is unclear how this particular split of total profits was arrived at but it is clear that granting the licensee with only 6.67 percent of residual profits is not much compensation for licensing a valuable intangible assets.

When the IRS pushed for an even higher royalty rate, Medtronic responded by reducing its royalty rate to 20 percent of end user sales. Under this lower royalty rate, the Puerto Rican affiliate would capture 60 percent of residual profits. The trial court ultimately reached a middle ground position deciding on the 30 percent royalty rate, which would grant the licensee with 40 percent of residual profits.

The Appeals Court has asked the taxpayer to quantity the implications of its licensee risk taking argument. My recent article on the determination of intercompany royalties using profits based approaches notes that a licensee deserves a portion of residual profits even if it does not own any of the valuable intangible assets as compensation for bearing additional risk from utilizing valuable intangible assets of another entity.  BEPS Discussion Draft on Action 9 (paragraph 63) notes:

“Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.”

This passage is a succinct statement of the vast financial economics literature on the economics of both leasing equipment and licensing intellectual property. Rather than restate the financial economists, let’s illustrate with a simple example where the risk-free rate is 4 percent and the overall cost of capital for a medical device multinational is 10 percent. This difference between these rates represents the premium for bearing systematic risk including both ownership risk and commercial risk. This passage notes that the licensee deserves the portion of this risk premium related to bearing commercial risk, while the licensor deserves both the risk-free rate and any premium for bearing ownership risk.

The IRS position is that the licensee does not deserve any additional risk premium, which violates basic financial economics. The taxpayer’s position would be supported if one could assert the premise that only the licensee bears systematic risk, which ignores the role of ownership risk. The trial court’s decision to set the intercompany royalty rate at 30 percent and hence grant the licensor with 60 percent of residual profits grants the licensor with both the risk-free rate and the premium for bearing ownership risk. As such, the licensee’s share of residual profits compensates it for bearing commercial risk.

The Appeals Court’s reluctance to accept the trial court decision stems from the fact that no such analysis was formally presented. Whether a formal analysis would lead to a higher or lower royalty rate remains to be seen.

[1] “Arm’s-Length Royalties in Light of BEPS and Uniloc”, Journal of International Taxation, November 2015.