The IRS has appealed its Tax Court loss in Medtronic, Inc. v. Commissioner
to the Eighth Circuit Court of Appeals. The Tax Court nullified a $1.2 billion tax assessment for the 2005 and 2006 tax years based on transfer pricing determinations made in connection with a licensing agreement between Medtronic and its Puerto Rican subsidiary.
Medtronic is engaged in the development, manufacture, marketing and sale of regulated medical devices. In 2002, the company transferred its Puerto Rican business operations from a Medtronic U.S. affiliate to a new Puerto Rican entity, Medtronic Puerto Rico Operations (MPROC). At the same time, MRPOC and Medtronic entered into a royalty-bearing license agreement which provided MPROC the right to use Medtronic’s trademark and technology to manufacture and sell certain medical devices. MPROC purchased components from Medtronic’s U.S. plants, manufactured finished products in Puerto Rico and sold the products to Medtronic’s U.S. distribution entity for eventual sale to customers. The research and development activities associated with the licensed rights were conducted by Medtronic.
In an audit of Medtronic’s 2002 tax return, the IRS analyzed the intercompany transactions in question and the transfer prices among MPROC and Medtronic and ultimately agreed to royalty rates for certain products. This agreement was the subject of a memorandum of understanding (MOU), which provided that Medtronic would apply the agreed royalty rates on its as filed returns and the IRS would respect those royalty rates, so long as there are no significant changes in any underlying facts.
The IRS again examined Medtronic for the 2005 and 2006 tax years. As part of the examination, the IRS ultimately assessed Medtronic approximately $1.2 billion in additional taxes – arguably abandoning the agreement reached in the MOU from the 2002 examination. Medtronic contested the IRS determination in Tax Court.
The Tax Court found in favor of Medtronic, determining that the IRS’s Section 482 allocations were arbitrary, capricious or unreasonable. The IRS had asserted that the comparable profits method (CPM) was the best method for determine the appropriate allocations of profit while Medtronic argued that the comparable uncontrolled transaction (CUT) method cited in the MOU continued to be the best method. The Tax Court found that, under the facts of the case, the CUT method is the best method for determining the arms-length rate, but made certain adjustments to arrive at the royalty rates cited in the decision. The Tax Court’s ruling essentially put Medtronic in the substantially the same position as reflected on their tax return and one that was consistent with the MOU.
The Medtronic decision is yet another loss for the IRS in a string of recent transfer pricing cases. In light of the results in other similar cases, the IRS likely faces an uphill battle in trying to enforce transfer pricing rules through the courts. The outcome of the appeals proceedings may represent significant evidence for taxpayers to consider when planning and assessing transfer pricing strategies. Taxpayers would also be well advised as to the lessons learned about past “agreements” with the IRS on transfer pricing matters. In the case of Medtronic, an MOU as to the appropriate pricing was not apparently not enough to stave off costly litigation and controversy notwithstanding Medtronic’s victory in Tax Court.
Partner, Washington National Tax Office
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Tax – Manager, Washington National Tax Office
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