In Brief

Medtronic Inc. & Consolidated Subsidiaries v. Commissioner (T.C. Memo. 2016-112) is the latest defeat for the U.S. Internal Revenue Service ("IRS") in a string of transfer pricing losses. The IRS sought to increase royalties payable from a Puerto Rico affiliate to Medtronic, Inc. ("Medtronic US" or "Taxpayer") by $US1.4 billion. The Tax Court rejected the IRS's proposed transfer pricing method as arbitrary, capricious, and unreasonable. The court instead accepted Medtronic US's chosen transfer pricing method, albeit with some adjustments.

Background

Medtronic US and its affiliates develop and sell medical devices all over the world. Medtronic US, the U.S. parent of the Medtronic group during the years at issue, indirectly owned a Puerto Rican manufacturing entity (Medtronic Puerto Rico Operations Co, "Medtronic PR"). Principally at issue in this case were the royalties paid by Medtronic PR to Medtronic US for the use of certain intangibles in Medtronic PR's manufacture of highly regulated, class III medical devices ("Devices").

Medtronic PR was an FDA-regulated manufacturer responsible for, inter alia, testing, sterilizing, and quality control with respect to the finished Devices it manufactured. Medtronic PR employed engineers and other highly trained personnel, as the manufacturing process was complex—sometimes taking seven to 14 days to complete a single Device. Further, some processes could not be done automatically and required skilled workers to complete them by hand. Medtronic PR bore material market risk and focused intently on quality because the finished Devices were implanted in human patients. Defects meant possible deaths.

For the 2005 and 2006 tax years, Medtronic PR paid royalties to Medtronic US pursuant to certain licenses ("Licenses") for the use of the intellectual property necessary to manufacture the Devices. Medtronic had determined the arm's-length royalty rates for the Licenses using the comparable uncontrolled transaction ("CUT") method. The IRS took the position that the Taxpayer should have instead used the comparable profits method ("CPM"). The IRS determined that Medtronic PR's profits were in excess of an arm's-length return and, accordingly, made significant upward adjustments to the royalties payable to Medtronic US under the Licenses.

The IRS had audited the same intercompany transactions for the 2002 tax year, similarly finding that the royalty rates were too low. The parties had settled this audit by executing an informal memorandum of understanding ("2002 MOU") pursuant to which Medtronic US agreed to use prescribed (higher) royalty rates and system profits allocations. For 2005 and 2006, however, the IRS asserted that the royalties were again too low—notwithstanding that they comported with the MOU.

The Court's Holding

The IRS had concluded that: (i) Medtronic PR performed functions less complex that those performed by Medtronic US and could have been replaced by an unrelated contract manufacturer, and (ii) Medtronic PR's contributions did not rise to the level of non-routine intangibles (which could have justified greater value being allocated to Medtronic PR). The IRS's expert used a CPM to determine the value of Medtronic PR's "routine" contribution and assigned the remaining system profit to the U.S. operations. He then computed appropriate royalty rates to achieve that result.

The court took issue with this analysis. The IRS expert had dismissed the importance of quality control and artificially reduced Medtronic PR's role to the mere assembly of components. In addition, the court raised technical concerns with the IRS's choice of comparables, profit level indicators, and the fact that multiple independent, intercompany transactions were unnecessarily aggregated for purposes of the analysis. (That is, once the expert determined a return for Medtronic PR, he assigned all remaining profit to Medtronic's US operations, without determining arm's-length returns for the various intercompany transactions.)This approach resulted in an unreasonably small allocation of profits to Medtronic PR. Accordingly, the court rejected the IRS's adjustments as arbitrary, capricious, and unreasonable.

The court accepted the Taxpayer's CUT method but made adjustments to account for certain differences between the Licenses and the comparable transaction relied on by the Taxpayer (a license between Medtronic US and a third party for some of the same patents). Thus, although the court agreed that the CUT method was the best method under the circumstances, it made corrective adjustments to arrive at its own royalty rates—which were lower than the rates the IRS had sought but higher than those asserted by the Taxpayer.

Implications

Given the fact intensity of this case, as with most transfer pricing cases, drawing broad conclusions is difficult. That said, there are a few insights to be gleaned from the court's lengthy ruling. Perhaps most notable is simply the court's continued willingness to reject IRS allocations in the transfer pricing context, notwithstanding the high bar of "arbitrary, capricious, and unreasonable." This is welcome news for practitioners and taxpayers, given that aggressive transfer pricing audits seem to be on the uptick. Also well received is the court's disinclination to follow the IRS's perceived preference for aggregating transactions and for using profit-based methods for intangible property transfers. Finally, even though the facts will inevitably differ from case to case, this opinion could provide additional ammunition to taxpayers seeking to allocate more income to offshore contract manufacturers, on the grounds that they have a highly skilled workforce and perform important quality control functions.