The purpose of the most recent decision in the Medtronic saga1 extends and refines the prior analysis of one of five connected controlled transactions within Medtronic's controlled group of multinational medical device producers and suppliers. The transactions may be described as follows:
- Medtronic licensed patented and unpatented intangible property related to the design and production of sophisticated medical devices to a controlled Puerto Rican subsidiary ("MPROC"), which served as the manufacturer. The intangible property related to (i) implantable pacemakers, cardioverter defibrillators, cardiac resynchronization devices, neurostimulation devices, and (ii) connective leads.
- Medtronic licensed its trademark intangible assets to MPROC.
- Medtronic sold manufactured product components and sub-assemblies to MPROC.
- MPROC sold finished medical devices to a U.S. group company for resale worldwide.
- Medtronic licensed the same intangible assets related to products (i) and (ii) described above to a controlled Swiss manufacturer that began device and leads production operations after MPROC. The Swiss affiliate paid royalties at the same rates as MPROC to Medtronic.2
The first two transactions – license of manufacturing intangible property and license of trademarks – were the main subject of a period of examination controversy that concluded with the I.R.S. adjusting the royalty income of the U.S. Medtronic licensor for tax years 2005 and 2006. The adjustments included additional income necessary for the royalty to be arm's length as determined under the comparable profits method ("C.P.M.") analyses performed by the I.R.S.
Medtronic's 2005 and 2006 position originated in an M.O.U. settlement with the I.R.S. involving the same transactions and issues, but in respect of Medtronic's 2002 tax year. That settlement was based on an agreed division of profit between the U.S. and MPROC but not on a specific transfer pricing method. The settlement outcome nonetheless informed the transfer pricing position of Medtronic for the tax years 2005 and 2006. Medtronic applied the comparable uncontrolled transaction ("C.U.T.") method to determine its 2005 and 2006 non-trademark income using a licensing agreement between Medtronic and Pacesetter, a Siemens group company active in the cardiac rhythm disease management business, concluded for the purpose of settling a medical device patent litigation matter between the two competing companies in the early 1990's. Medtronic continued to rely on its C.U.T. method application to argue that the M.O.U. outcome was arm's length and petitioned the Tax Court to vacate the proposed I.R.S. income adjustments for 2005 and 2006.
The value of the second transaction was resolved easily by the Tax Court using expert evidence of trademark royalty rates. The decision noted there was an error in the calculation of the intercompany inventory sales revenue that would be corrected during the proceedings.3 Though the focus of the controversy became the non-trademark licensing transaction, all five transactions excepting the Swiss licensing transaction were referenced by Medtronic and the I.R.S. in making arguments about the division of profit between Medtronic and MPROC.
2016 TAX COURT DECISION
In 2016, the Tax Court decided for the most part for Medtronic, though several adjustments were made to the non-trademark royalty rates (one rate for devices, a different rate for leads) to improve the comparability of the terms and circumstances of the independent Pacesetter agreement primarily relied on by Medtronic with the terms and circumstances of the licensing agreement between Medtronic and MPROC. Much of the 2016 Tax Court decision dealt with the facts of the transactions and the Medtronic burden of demonstrating that the I.R.S. position was arbitrary, capricious, or unreasonable. The I.R.S. was also found to have abused its authority in making the allocation.
On the question of whether the allocations used by Medtronic satisfied the arm's length method, the Tax Court reasoned that three adjustments were required to meet the comparability standard. These adjustments related to (i) the supply of non-patented design and production know-how, (ii) profit potential, and (iii) the licensed property (cardiac product intangibles as distinct from neurology product intangibles). After adjusting for differences, the Tax Court concluded that the adjusted C.U.T. was the best method. The outcome of the first decision raised the devices royalty rate by 15% and the leads rate by 7%. These rates, the court noted, were not significantly different from those agreed between Medtronic and the I.R.S. in the 2002 M.O.U.
The I.R.S. argued exclusively for its comparable profits method ("C.P.M.") approach and against the Medtronic C.U.T. method during the examination of tax years 2005 and 2006, during Medtronic's appeal to I.R.S. Appeals Office, and during the Tax Court proceedings that culminated in the 2016 decision. The I.R.S. provided the court with no expert testimony to assist it in estimating an adjustment to the Medtronic royalty rate to remedy several identified comparability shortcomings identified in the Medtronic C.U.T. analysis.4
The I.R.S. appealed the 2016 Tax Court decision, arguing that (i) the decision did not adequately dispose of the question of whether Medtronic's C.U.T. was the best method, and (ii) the Tax Court did not make sufficient findings of fact to conclude that Medtronic's C.U.T. met the comparability standards of Treas. Reg. §1.482-4(c) (2). The I.R.S. was successful on appeal to the 8th Circuit Court of Appeals, and the case was remanded to the Tax Court to make the required findings of fact and determine the best method.
THE TASKS BEFORE THE COURT
As an initial matter, the Tax Court listed the tasks assigned by the 8th Circuit:
- Determine whether the Pacesetter agreement is a C.U.T.
- Determine whether the Tax Court made appropriate adjustments to the Pacesetter agreement, if it were a C.U.T.
- Determine whether the circumstances between Pacesetter and Medtronic were comparable to the licensing agreement between Medtronic and MPROC and whether the Pacesetter agreement was an agreement created in the ordinary course of business
- Determine the degree of comparability of the Pacesetter agreement's contractual terms and those of the MPROC licensing agreement
- Determine how the different intangibles in the two agreements affected the comparability of the Pacesetter agreement and the MPROC licensing agreement
- Compare and contrast the results under the C.U.T. method using the Pacesetter agreement with or without adjustments with those under the C.P.M., and determine which of the two methods is the best method
As an introduction to these tasks and its analysis, the Tax Court provided some general commentary to place its assigned tasks in the context of the transfer pricing regulations and the case law.
The Tax Court cited Sundstrand5 to establish its role in determining whether the I.R.S. position underlying a notice of deficiency was arbitrary, capricious, or unreasonable. When these conditions are met, the next step is for the taxpayer to show that the allocations of income or expense among the related parties that satisfy the arm's-length standard.6 The decision explains the role of the court when the position of the I.R.S. is viewed to be unreasonable but the taxpayer does not meet its burden of demonstrating the proper method to be used:
If neither party has proposed a method that constitutes "the best method," the Court must determine from the record the proper allocation of income. Sundstrand Corp., 96 T.C. at 354. After hearing expert witnesses during further trial and reviewing the parties' positions, we conclude that there are some benefits to the CUT, and the Pacesetter agreement is an appropriate comparable as a starting point. We are concerned that there is only one comparable, that adjustments need to be made, and that if too many adjustments are made, the Pacesetter agreement might cease to be useful even as a starting point.7
Consistent with the decision in Medtronic I, the Tax Court found that the Pacesetter agreement by itself, without any adjustment for comparability, was not a C.U.T. The Tax Court rethought the appropriateness of the adjustments it made in the first trial, and on remand, made different adjustments. Ultimately choosing the application of an alternate, unspecified method but with Pacesetter as its cornerstone despite its stated misgivings. The Tax Court made findings of fact and reached conclusions on the questions posed in tasks 3-5. This set the court up to answer question 6 concerning the best method.
1. Medtronic, Inc. & Consol. Subs. v. Commr., T.C. Memo. 2022-84 ("Medtronic III"), on remand from 900 F.3d 610 (8th Cir. 2018) ("Medtronic II"), vacating and remanding T.C. Memo. 2016-112("Medtronic I").
2. It was agreed by the parties that the Swiss royalty rate(s) would be adjusted to equal the MPROC royalty rate(s) determined by the court. No detailed facts of this transaction or of any transfer pricing analysis were presented.
3. This sales revenue was critical to the final determination of the arm's length amount of the royalty because the royalty was a function of the sales revenue and an acceptable royalty rate.
4. The I.R.S. did not present an adjusted C.P.M. in the second Tax Court trial, though the Tax Court commented that such an analysis would have been considered if presented.
5. Sundstrand Corp. v. Commr., 96 T.C. 226, 353 (1991) (citing G.D. Searle & Co. v. Commr., 88 T.C. 252, 358 (1987), and citing Eli Lilly & Co. v. Commr., 84 T.C. 996, 1131 (1985), aff'd. on this issue, rev'd in part and rem'd, 856 F.2d 855 (7th Cir. 1988)).
6. Eli Lilly & Co. v. Commr., 856 F.2d 855, 860 (and the cases cited therein).
7. Medtronic III at p. 49.
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