The case between Medtronic, one of the largest medical equipment developers in the world, and the Commissioner of Internal Revenue, the head of the highest taxing authority in the U.S., is an important one to watch, not only because of the $1.35 billion in potential tax revenue on the line, but because of what it might mean for international business.
For tax years 2005 and 2006, the IRS proposed a transfer pricing adjustment resulting in a tax deficiency of over $1.35 billion. Medtronic filed a lawsuit in the U.S. Tax Court, and in June of 2016, the Tax Court issued its decision disagreeing with the IRS’s allocation of income. The Tax Court stated that the IRS’s position was “arbitrary, capricious, and unreasonable” and decreased the tax deficiency to $14 million. The IRS appealed the Tax Court’s decision. On appeal, the Eighth Circuit found several flaws with the Tax Court’s reasoning, and vacated the lower court’s order, remanding the case for further consideration. The appellate court’s decision was 3-0, including a concurring opinion. The Eighth Circuit Court of Appeals vacated the Tax Court’s decision and remanded the case for further consideration in Medtronic v. Commissioner.
Medtronic US (parent) and its distributer, Medtronic USA, Inc. are located in the United States and Medtronic Puerto Rico Operations Co. (Medtronic Puerto Rico) is located in Puerto Rico. Medtronic Puerto Rico licenses from Medtronic US intangibles necessary for the manufacture and sale of certain medical devices.
Medtronic selected the comparable uncontrolled transaction (CUT) method as the best method to determine the royalty rate for the licensing of intangible property. Medtronic relied on the royalty rates as agreed upon with the IRS in a Memorandum of Understanding (Memorandum) during the close of the 2002 tax year audit. The IRS agreed to apply the Memorandum’s royalty rates in future years “as long as there were no significant changes in any underlying facts.” However, during the 2005 and 2006 audit, the IRS changed course and determined that the comparable profits method (CPM) was the best method for the intercompany licensing arrangement.
There are several transfer pricing methodologies available to support the arm’s length nature of intercompany licensing transactions: The CUT method, the CPM, the profit split method, and unspecified methods. The “best method” is defined as the method that provides the most reliable measure of an arm’s length result under the facts and circumstances of the controlled transaction under review. There is no strict priority of methods and no method will invariably be considered to be more reliable than others. (Treasury Regulation Section 1.482.)
The CUT method evaluates the royalty rate based on comparable licensing agreements, either internal or external; whereas the CPM evaluates the profit associated with functions, risks, and assets of the tested party based on third-party comparable companies with similar functions, risks, and assets. The IRS’s expert performed functional analysis of Medtronic and determined that the CPM was the best method based on the functions performed, risks assumed, and assets owned by Medtronic Puerto Rico; thereby reallocating most of the income to the U.S.
Medtronic filed suit in the U.S. Tax Court, arguing that the CUT method was the best method. The tax court determined that the CUT method was the best method, but disagreed with the application of the CUT method by Medtronic. The tax court engaged in its own analysis and determined that the licensing agreement between Medtronic and Pacesetter (Pacesetter agreement) was comparable to the intercompany licensing agreement between Medtronic and Medtronic Puerto Rico. This analysis resulted in a revised tax deficiency of $14 million.
The IRS disagreed and appealed the Tax Court’s decision to the Eight Circuit. The Eight Circuit disagreed with the Tax Court in its use of the Pacesetter agreement as the best CUT to calculate the arm’s length result. The Eighth Circuit determined that the Pacesetter agreement was not considered to be comparable to Medtronic agreement for the following reasons:
The Eighth Circuit found that the Tax Court’s findings were insufficient to support its use of the Pacesetter agreement as a comparable transaction. The case was sent back to the Tax Court, with instructions to produce a more detailed justification for its decision. The Tax Court has the option to provide more details on its methodology or it may request more information from the two parties. Either way, the appellate court’s opinion, along with the concurrence, suggest that it will be difficult for the Tax Court to use the Pacesetter agreement as a comparable transaction on appeal. It is possible that there may be future negotiations between the IRS and Medtronic that might result in a settlement.
The Eighth Circuit’s decision may have a broader impact on future transfer pricing cases. On the horizon is a high-profile transfer pricing case: a $3.3 billion claim against Coca-Cola. Again, the IRS has asserted that the royalties payable by certain foreign licensees to the parent company for the licensing of intellectual property were not arm’s length. Coke is alleged to have underpriced those royalties by using the CUT method, whereas the CPM, which the IRS prefers, would generate a much greater tax obligation.
The IRS filed a pretrial memorandum against Coke in February of this year, so the case is moving towards a trial in Tax Court. The ongoing legal battle is certain to attract attention and a victory by the IRS, in Tax Court or on appeal, and may encourage the IRS to be even more aggressive in pursuing what it sees as tax avoidance via transfer pricing that generates potential income shifting to offshore low taxing jurisdictions.
The Eighth Circuit’s ruling in the Medtronic case may indicate that the courts are becoming willing to scrutinize transfer pricing more closely. This enforces the importance of transfer pricing compliance, including a supportable selection of the best method, in case of any IRS challenges. For more information, contact your Citrin Cooperman advisor or a member of our Transfer Pricing Practice.