Medtronic Inc. et al., (CA 8 8/16/2018) 122 AFTR 2d ¶ 2018-5142
The Court of Appeals for the Eighth Circuit vacated a Tax Court decision that used the comparable uncontrolled transactions method for determining transfer pricing between Medtronic and its Puerto Rican subsidiary. The Eighth Circuit found that the the Tax Court’s factual findings were insufficient and remanded the case with instructions to make more complete factual findings.
Background. Code Sec. 482 gives IRS broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations are necessary either to prevent evasion of tax or to reflect clearly the income of the corporations. To determine true taxable income, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. (Reg. § 1.482-1(b)(1)) The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. (Reg. § 1.482-1(c)(1))
The regs provide four methods to determine the arm’s length amount to be charged in a controlled transfer of intangible property:
…the comparable uncontrolled transaction (CUT) method, which evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction;
…the comparable profits method (CPM), which evaluates whether the amount charged in a controlled transaction is arm’s length according to objective measures of profitability derived from transactions of uncontrolled taxpayers that engage in similar business activities under similar circumstances;
…the profits split method, which evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss; and
…unspecified methods, as described in Reg. § 1.482-4(d).
There is no strict priority of methods, and in determining which method provides the most reliable measure of an arm’s length result, the two primary factors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of data and assumptions used in the analysis. (Reg. § 1.482-1(c)(2))
If uncontrolled transactions involve the same or comparable intangible property, then the CUT method will generally yield the most reliable arm’s length measurement. (Reg. § 1.482-4(c)(2)(ii)) Intangible property is considered comparable if it was created under similar circumstances and was “used in connection with similar products or processes within the same general industry or market; and [it has] similar profit potential.” (Reg. § 1.482-4(c)(2)(iii)(B)) Other factors to consider when evaluating comparability include relevant functions, contract terms, risks, economic conditions, and property or services. (Reg. § 1.482-1(d)(1))
Where IRS has determined deficiencies based on Code Sec. 482, the taxpayer bears the burden of showing that the allocations are arbitrary, capricious, or unreasonable. (Sunstrand Corp., (1991) 96 TC 226) If the adjustments set forth in the notice of deficiency are determined to be arbitrary, capricious, or unreasonable, then the taxpayer must next show that the allocations it proposes satisfy the arm’s-length standard. (Veritas, (2009) 133 TC 297)
Facts. Medtronic is a medical device company; it manufactures devices and leads. The parent company, Medtronic U.S, is located in the United States, and its device manufacturer, Medtronic Puerto Rico, is located in Puerto Rico. Medtronic allocates the profits earned from its devices and leads between Medtronic U.S. and Medtronic Puerto Rico through its intercompany licensing agreements.
Medtronic’s 2005 and 2006 consolidated tax returns used the comparable uncontrolled transactions (CUT) transfer pricing methods to determine the royalty rates paid on its intercompany licenses. IRS audited the 2005 and 2006 tax years and determined that the CPM method — not the CUT method — was the best way to determine arm’s-length price for Medtronic’s intercompany licensing agreements for those two years. IRS assessed deficiencies for those two years of over $548 million and over $810 million, respectively.
Medtronic filed suit in the Tax Court, arguing that the CUT method, not the comparable profits method, was the best method for determining an arm’s length price for the intercompany licenses. The Tax Court held that IRS’s “allocations were arbitrary, capricious, or unreasonable.” The Court also found that the comparable profits method “downplayed” Medtronic Puerto Rico’s role in ensuring the quality of the devices and leads, that it did not reasonably attribute a royalty rate to Medtronic’s profits, that it used an incorrect return on assets approach, that it improperly aggregated the transactions, and that it ignored the value of licensed intangibles.
The Tax Court then engaged in its own valuation analysis. It ultimately decided that Medtronic’s CUT method was the best way to determine an arm’s length royalty rate for intercompany agreements, but made a number of adjustments. (Medtronic, TC Memo 2016-112; see Tax Court rejects IRS’s transfer pricing methodology in medical device license case)
IRS then filed this appeal, seeking a reversal and a remand for a reevaluation of the best transfer pricing method and a recalculation of the arm’s length royalty rate.
Circuit Court vacates and remands. The Circuit Court vacated and remanded the case with instructions to make more complete factual findings.
The Circuit Court said that the Tax Court applied the “Pacesetter agreement” as the best CUT to calculate the arm’s length result for intangible property. The Pacesetter agreement was entered into by Pacesetter’s parent company and Medtronic US. As part of the agreement, the parties cross-licensed their pacemaker and patent portfolios. They additionally agreed that Medtronic would receive a $75 million lump sum payment plus a 7% royalty for all future sales of cardiac stimulation devices or components covered under Medtronic’s patents in the United States.
The Tax Court determined that the Pacesetter agreement was an appropriate CUT because it involved similar intangible property and had similar circumstances regarding licensing.
The Circuit Court said that the Tax Court did not address in sufficient detail whether the circumstances of the settlement between Pacesetter and Medtronic U.S. were comparable to the licensing agreement between Medtronic U.S. and Medtronic Puerto Rico. The Tax Court did not decide whether the Pacesetter agreement was one created in the ordinary course of business. The Circuit Court pointed to Reg. § 1.482-1(d)(4)(iii)(A)(1), which provides that transactions that were not made in the ordinary course of business will not generally be considered reliable for arm’s length purposes.
Additionally, the Circuit Court said 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. The Circuit Court cited Reg. § 1.482-1(d)(3)(ii)(A)(1), which provides that “determining the degree of comparability between the controlled and uncontrolled transactions requires a comparison of the significant contractual terms that could affect the results of the two transactions.” 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 Circuit Court said that, in the absence of findings regarding the degree of comparability between the controlled and uncontrolled transactions, it could not determine whether the Pacesetter agreement constituted an appropriate CUT. It cited Reg. § 1.482-4(c)(2)(iii)(B)(2)(vii) (“In evaluating comparability of the circumstances of the controlled and uncontrolled transactions… specific factors that may be particularly relevant include… [t]he existence and extent of any collateral transactions or ongoing business relationships between the transferee and transferor.”)
It also noted that 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, including “any technical know-how or design information, manufacturing, marketing, and/or processing information or know-how, designs, drawings, specifications, software source code or other documents directly or indirectly pertinent to the use of the Licensed patents.” The Medtronic Puerto Rico licensing agreement, on the other hand, did not exclude such intangibles.
The Circuit Court concluded that it could not determine that appropriateness of using the Pacesetter agreement as a CUT without additional findings regarding the comparability of the remaining intangibles.
Finally, the Tax Court did not decide the amount of risk and product liability expense that should be allocated between Medtronic U.S. and Medtronic Puerto Rico. IRS contended that Medtronic Puerto Rico bore only 11% of the devices and leads manufacturing costs, which included its share of the product liability expense, and that therefore Medtronic Puerto Rico’s allocation of profits should be a similar percentage based on its economic contribution. The Tax Court rejected IRS’s 11% valuation, concluding that it was unreasonably low because it did not give enough weight to the risks that Medtronic Puerto Rico incurred in its effort to ensure quality product manufacturing. Accordingly, the Tax Court allocated almost 50% of the device profits to Medtronic Puerto Rico. In doing so, the Tax Court also rejected IRS’s comparable profits methods because it found that the comparable companies used by IRS 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, the Circuit Court said that it lacked sufficient information to determine whether the Tax Court’s profit allocation was appropriate.