8th Circuit vacates Tax Court decision in Medtronic transfer pricing case

Tax Hot Topics newsletterThe 8th Circuit Court of Appeals, in Medtronic, Inc. v. Commissioner, No. 17-1877 (8th Cir. 2018), vacated the Tax Court’s prior ruling and remanded the case. It found the lower court failed to conduct the necessary analysis before adopting a transfer pricing method for calculating Medtronic’s arm’s-length royalty rates for intercompany licenses, and held it could not rule on the matter without further factual findings.

The decision to vacate suggests that the Tax Court’s Medtronic analysis should not be considered a model for how the comparable uncontrolled profits (CUT) method should be applied. Taxpayers may want to bring more analytical rigor to a comparability analysis under that, or any other, transfer pricing method than the Tax Court’s analysis may suggest is required under the Section 482 regulations.

The Tax Court originally concluded that the IRS’s application of the comparable profits method (CPM) to Medtronic’s Puerto Rican manufacturing affiliate, Medtronic Puerto Rico Operations Co. (MPROC), was arbitrary, capricious or unreasonable.

Medtronic had previously used the CUT method, supported by the residual profit split method (RPSM) to price the transaction between Medtronic and MPROC. Those methods, and the resulting royalty rates, were memorialized in a Memorandum of Understanding (MOU) between the IRS and Medtronic following an audit of Medtronic’s 2002 tax year. The MOU, which was to apply to 2002 and all future years, provided there were no significant changes in any underlying facts. Despite this, the IRS applied the CPM to determine MPROC’s results in an audit of the 2005-2006 tax years. The CPM reduced MPROC’s operating profits significantly during the tax years at issue.

A key consideration in the Tax Court’s analysis of the appropriate transfer pricing method was MPROC’s role in producing the pacemaker devices and leads before they went to market. According to the court, product quality was paramount in the medical device industry and in the pacemaker industry in particular. Any failure by a pacemaker, once implanted in a patient, could create significant liability for a medical device company. As such, the court determined that MPROC’s role was not akin to that of a routine electronics component manufacturer, as the IRS asserted.

For the Tax Court, MPROC’s vital role compelled rejecting the IRS’s proposed CPM and using the CUT method. As a basis for the CUT analysis, the court used an agreement from prior patent infringement litigation between Medtronic and Siemens (the “Pacesetter Agreement”). However, it recognized the agreement was an “imperfect comparable,” and so set about making several adjustments to it.

The 8th Circuit Court held it was unable to evaluate the Tax Court’s decision to use the Pacesetter Agreement, stating the Tax Court’s factual findings were insufficient. Specifically, it found the Tax Court did not sufficiently compare the circumstances of the Pacesetter Agreement to Medtronic’s licensing agreement with MPROC. It pointed to the Tax Court’s failure to make determinations required by Treasury regulations, namely assessing whether the Pacesetter Agreement was created in the ordinary course of business and analyzing the degree of comparability between the two agreements.

The court also held the Tax Court didn’t evaluate how that varying treatment of intangibles impacted the comparability of the two agreements, and that the lower court failed to allocate the amount of risk and product liability expense between Medtronic and MPROC. It instructed the Tax Court to make these “essential” findings upon remand.

David Sites
Partner, Washington National Tax Office
T +1 202 861 4104

David Zaiken
Managing Director, Washington National Tax Office
T +1 202 521 1543

Cory Perry
Senior Manager, Washington National Tax Office
T +1 202 521 1509

Mike Del Medico
Manager, Washington National Tax Office
T +1 202 521 1522

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