Appeal's Court Reverses Tax Court Transfer Pricing Ruling
The Court of Appeals for the Eighth Circuit vacated the U.S. Tax Court decision in a long-running and closely watched transfer pricing case involving Medtronic and its Puerto Rico subsidiary.
The appeals court determined that the Tax Court had rejected the IRS’s transfer-pricing method, and adopted that of the taxpayer, without the analysis required under transfer-pricing regulations. As a result, the appeals court wasn’t able to determine whether the court “applied the best transfer pricing method for calculating an arm’s length result or whether it made proper adjustments under its chosen method.” It vacated the Tax Court’s order and remanded the case for further consideration.
Medtronic used the comparable uncontrolled transactions (CUT) method to determine the royalty rates paid on its intercompany licenses. However, the IRS audited the medical device company’s 2005 and 2006 tax years and determined that another method was the best way to determine arm’s-length price for those two years.
Four possible calculations
Under the Code of Federal Regulations, there are four methods to determine the arm’s-length amount to be charged in a controlled transfer of intangible property:
1. The CUT method evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by referring to the amount charged in a comparable uncontrolled transaction.
2. The comparable profits method (CPM) evaluates whether the amount charged is arm’s length based on objective measures of profitability derived from transactions of uncontrolled taxpayers that engage in similar business activities under similar circumstances.
3. The profit-split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by referring to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss.
4. Unspecified methods consider the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives and only enter into a transaction if none of the alternatives is preferable.
IRS assesses deficiencies
The IRS determined that CPM — not the CUT method — was the best way to determine arm’s-length price for Medtronic’s intercompany licensing agreements for the two years in question. The IRS assessed deficiencies for those two years of more than $548 million and more than $810 million, respectively.
Medtronic filed suit in the Tax Court, countering that the CUT method was the best method.
The court held that the IRS’s “allocations were arbitrary, capricious, or unreasonable” and that CPM “downplayed” the Puerto Rican unit’s role in ensuring the quality of the devices and leads the company made. It also maintained that the IRS:
· Hadn’t reasonably attributed a royalty rate to Medtronic’s profits,
· Had used an incorrect return on assets approach,
· Had improperly aggregated the transactions, and
· Had ignored the value of licensed intangibles.
Appeals court’s valuation
The court then made its own valuation analysis. It decided that Medtronic’s CUT method was the best way to determine an arm’s-length royalty rate for intercompany agreements, but it made several adjustments.
The IRS appealed, seeking a reversal and a remand for a re-evaluation of the best transfer pricing method and a recalculation of the arm’s-length royalty rate.
The appeals court vacated and remanded the case with instructions to make more complete factual findings.
The court said that the Tax Court had applied the “Pacesetter agreement” as the best CUT method to calculate the arm’s-length result for intangible property. As part of that agreement between Medtronic and Siemens Pacesetter Inc., the parties cross-licensed their pacemaker and patent portfolios, with Medtronic to 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 had determined that the Pacesetter agreement was an appropriate CUT method because it involved similar intangible property and had similar circumstances regarding licensing.
Ordinary course of business
The appeals court, however, said that the Tax Court hadn’t sufficiently addressed whether the circumstances of the Pacesetter settlement were comparable to the licensing agreement between Medtronic U.S. and its Puerto Rico unit. The court hadn’t decided whether the Pacesetter agreement was one created in the ordinary course of business. The appeals court pointed to the regulation that says transactions not made in the ordinary course of business won’t generally be considered reliable for arm’s-length purposes.
Moreover, the Tax Court hadn’t analyzed the degree of comparability of the Pacesetter agreement’s contractual terms to those of the Medtronic Puerto Rico licensing agreement, the appeals court ruled. It cited a regulation 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 court acknowledged that the Pacesetter agreement included a lump sum payment and a cross-license, but it didn’t address how Pacesetter’s additional terms affected the degree of comparability to Medtronic Puerto Rico’s licensing agreement, which didn’t include a lump sum payment or cross-license.
The appeals court said that, without findings regarding the degree of comparability between the controlled and uncontrolled transactions, it couldn’t determine whether the Pacesetter agreement constituted an appropriate CUT method.
The question of intangibles
It also noted that the Tax Court hadn’t evaluated how the different treatment of intangibles affected the comparability of the Pacesetter agreement to the Medtronic Puerto Rico licensing agreement. The Pacesetter agreement was limited to patents and excluded all other intangibles. The Medtronic Puerto Rico licensing agreement, on the other hand, didn’t exclude intangibles.
The appeals court concluded that it needed additional findings regarding the comparability of the remaining intangibles.
Finally, the Tax Court hadn’t decided the amount of risk and product liability expense that should be allocated between Medtronic and its Puerto Rico unit. The IRS contended that Medtronic Puerto Rico bore only 11% of the devices and leads manufacturing costs and that allocation of profits should be a similar percentage. The court rejected the IRS’s 11% valuation, concluding that it was unreasonably low because it didn’t give enough weight to the risks that the Puerto Rico unit incurred in its effort to ensure quality product manufacturing.
The Tax Court allocated almost 50% of the device profits to the Puerto Rico unit. It rejected the IRS’s CPM because it found that the comparable companies used by the IRS didn’t incur the same amount of risk as Medtronic Puerto Rico did. 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 appeals court said that it lacked sufficient information to determine whether the Tax Court’s profit allocation was appropriate.
Bottom line: The appeals court remanded the case with instructions to make more complete factual findings (Medtronic, Inc. & Consolidated Subsidiaries v. Commissioner, No. 17-1866).
If your business deals with transfer pricing issues, please contact Turquoise Tax Advisory.