The Tax Court recently issued its second opinion in Medtronic v. Commissioner (T.C. Memo. 2022-84), rejecting the comparable profits method (CPM) approach proposed by the IRS in the case, and also rejecting the profit split method proposed by Medtronic. The Tax Court instead applied an unspecified method.
Medtronic is a global medical device company that makes and sells implantable medical devices. Medtronic, Inc. (“Medtronic U.S.”) owns the intangibles, manufactures proprietary components and distributes the products. A Puerto Rican subsidiary (“Medtronic P.R.”) assembles the products using a complex multi-step process with extensive quality control procedures. The issue addressed by the Tax Court was the appropriate intercompany royalty paid from Medtronic P.R. to Medtronic U.S.
In the initial Medtronic opinion (“Medtronic 1”), the Tax Court rejected the CPM approach proposed by the IRS, which would have resulted in a tax deficiency of approximately $1.4 billion. Instead, the Tax Court used a comparable uncontrolled transaction (CUT) approach that relied in part on a patent settlement and resulting license agreement. The Tax Court found a tax deficiency of approximately $14 million.
On appeal in “Medtronic 2,” the Eighth Circuit questioned the comparability of the patent-settlement-derived royalty because it was not made in the ordinary course of business and remanded the case to the Tax Court.
Upon receiving the case for a second time, the Tax Court applied an unspecified method in the recently issued “Medtronic 3.” The court again rejected the IRS’ CUT arguments, finding that Medtronic P.R.’s manufacturing was not routine, and that the IRS method did not compensate Medtronic P.R. for its quality-control function and product liability risk. The court ultimately applied a three-step, unspecified method to determine the appropriate royalties payable. Step one was a modified CUT as a starting point for an appropriate royalty. Step two was a CPM, modified for the asset intensity of Medtronic operations. Step three imposed an 80/20 split of the remaining profit between Medtronic U.S. and Medtronic P.R., respectively. This method substantially increases the tax deficiency from Medtronic 1 — but the deficiency has not yet been calculated.
The fact-specific nature of transfer pricing and the Tax Court’s choice of an unspecified method limit the conclusions that can be drawn from this opinion. However, despite the Tax Court’s rejection of the IRS’ CPM approach in this case, many commenters see this case as a partial win for the IRS.
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