20 June 2016 Tax court imposes a proper arm's length allocation method for transfer pricing On 9 June 2016, the U.S. Tax Court issued an opinion1 in which it concluded that transfer pricing adjustments the Internal Revenue Service (Service) made to Medtronic, Inc.'s (Medtronic US's) income for the 2005 and 2006 tax years were arbitrary, capricious and unreasonable. Specifically, the Court rejected the Service's value chain analysis approach, and found particular fault with the Service's failure to accord the proper weight to the role that quality control performed by Medtronic US's Puerto Rico manufacturing and sales entity played in the value chain. However, the Court also concluded that Medtronic US's application of the comparable uncontrolled transaction (CUT) method had significant deficiencies, thereby rendering the result unreasonable. Thus, the Court was forced to determine a proper arm's length allocation method for both devices and leads licenses, which it ultimately did by applying several adjustments to Medtronic US's proffered CUT. Further, the Court determined that the Service's alternative Section 367(d)2 argument was meritless, as no intangibles subject to that Code provision had been transferred. Medtronic US is a parent company of a consolidated medical technology group, with operations and sales worldwide. At issue in the present case is the company's manufacture and sale of Class III medical devices for its Cardiac Rhythm Disease Management (CRDM) and Neurological (Neuro) business units, both of which manufactured and sold both medical device pulse generators (devices) and physical therapy delivery devices (leads). For the years at issue, 2005 and 2006, Medtronic US owned Medtronic International Technology, Inc. (MITI), a US corporation. MITI owned Medtronic Holding Switzerland GmbH ("Swiss Holding"), a Swiss entity. Swiss Holding owned Medtronic Puerto Rico Operations Co. (MPROC),3 Medtronic Europe and Medtronic Galway, all of which were disregarded entities for US federal income tax purposes. In addition, as a vertically integrated company, Medtronic US had several component manufacturing branches: Medtronic Energy & Component Center (MECC), Medtronic Microelectronics Center (MMC), and Arizona Device Manufacturing (ADM). MPROC and Medtronic Europe purchased components from the component manufacturing branches, and in turn manufactured finished devices and leads4 and sold them in their respective geographic areas. In addition to routine functions that are common for parent companies, including accounting, tax, finance, treasury, legal, etc. … , Medtronic US was responsible for research and development (R&D) activities related to refinements for products that were already on the market. In addition, it was responsible for R&D for new products and indications. In addition, Medtronic US was highly involved in ensuring product quality, and was responsible for interpreting Food and Drug Administration (FDA) regulations, as well as guidance promulgated by other international regulatory agencies. In addition, Medtronic US produced quality manuals and policies for each of its business units, including CDRM and Neuro. MPROC employed almost 2,300 highly skilled workers across three branches, and the majority of the workers were involved in manufacturing. MPROC was responsible for, inter alia, its own talent acquisition and management, managing supplier relationships, and process design and improvement. It was also responsible for the quality of the devices and leads it manufactured, and spent time developing and revising its local quality policies and manuals. It also developed and managed its own quality system, a significant component of which was the corrective and preventive action (CAPA) program, which was designed to assess quality complaints and determine whether escalation to the components manufacturers was warranted. In furtherance of its business, Medtronic US entered into two key intercompany agreements that were at issue during trial:5 — Medtronic US licensed to MPROC the exclusive right to use, develop and enjoy the intangible property used in manufacturing devices for sale to customers in the United States and in manufacturing leads for sale worldwide (devices and leads licensing agreement) — Medtronic US, MPROC and Medtronic Europe entered into a supply agreement (Swiss supply agreement), whereby Medtronic Europe agreed to use its manufacturing operations in Switzerland to assist MPROC by manufacturing and supply the United States with devices when necessary, to meet excess demand in the United States. Under the terms of the agreement, Medtronic Europe would pay Medtronic US the same royalty that MPROC would have paid, had it manufactured and sold the devices itself. Medtronic Europe also agreed to pay the same trademark royalty to which MPROC was subject. The Service audited Medtronic US's 2002 tax return, and reviewed various intercompany transactions related to the devices and leads manufacture and sale, as well as the restructuring of its Puerto Rico operations. At the end of the audit, the examiner accepted Medtronic US's comparable uncontrolled transaction (CUT) method approach, which established an arm's length royalty rate of 29% for intercompany devices transactions and 15% for intercompany leads transactions, and an arm's length trademark royalty rate of 8%. However, the examiner also adjusted the transactions to increase their profit potential. Medtronic US agreed to make changes in its original CUT, and a memorandum of understanding (MOU) memorialized the informal agreement: royalty rates of 44% and 26%, for devices and leads, respectively. The MOU also included a profit split methodology to determine the percentage of system profit each of the related entities involved in the various transactions was to earn. Under this analysis, it was agreed that the system profit attributable to MPROC was to be between 35% and 41% for devices and between 42% and 48% for leads. The agreement in the MOU was to apply to 2002 and all future tax years, assuming no significant changes in any underlying facts. On its 2005 and 2006 returns, Medtronic US first calculated arm's length amounts based on its CUT analysis, or 29% and 15%, for devices and leads, respectively. It then applied the increased royalty rates and the profit split methodology, per the MOU. After applying the profit split methodology, Medtronic US reported additional royalty income on it Schedules M-3, totaling over $580,000,000 in additional royalty income. On its notice of deficiency for tax years 2005 and 2006, the Service based its applied the comparable profits method (CPM), and made adjustments totaling roughly $1.3 billion. The Service's primary argument was based on Section 482; alternatively, it argued that a Section 367(d) intangible property transfer must have taken place, for which Medtronic US must be compensated. At trial, the three remaining issues centered upon the devices and leads intercompany transactions, the Swiss supply agreement, and the Section 367(d) issue. At trial, Medtronic US argued that the royalty rates in the MOU exceeded the arm's length royalty rates reflected in the company's own CUT analysis. Since the Service's adjustments represented allocations that were much greater than what arm's length royalty payments should have been, they were by definition arbitrary, capricious and unreasonable. To support the contention that the Service's adjustments were arbitrary and capricious, Medtronic US presented a two-part argument. First, it alleged that the Service had abandoned its earlier position when it made an adjustment based on a CPM analysis. Second, Medtronic US argued that the Service failed to give appropriate weight to the importance of quality control in MPROC manufacturing, and in so doing, presented an analysis that did not assign MPROC an appropriate return commensurate with the risk it bore as the manufacturer of class III finished medical devices, which led to unreasonable adjustments. In response, the Service contended that the CPM, rather than the CUT, was the best method to determine the arm's length royalty rates for the intercompany devices and leads transactions, and that its Section 482 adjustments were not arbitrary and capricious. It was the Service's view that MPROC was only responsible for one critical function in Medtronic US's value chain: assembling finished products, which it did only with Medtronic US's significant oversight and assistance. In addition, the Service was of the opinion that Medtronic US's uncontrolled transactions were not comparable to the transactions at issue, and that quality control was not the determining factor in the success or failure of any medical device. Finally, the Service argued that its CPM analysis produced a result that was consistent with the commensurate with income (CWI) principle, while Medtronic US's application of the CUT method did not. In judicial proceedings challenging the Service's imposition of adjustments made pursuant to Section 482, a taxpayer must clear two hurdles to prevail. First, it must prove that the Commissioner abused his discretion by making allocations that are arbitrary, capricious and unreasonable.6 Second, it must show that its transfer pricing methodology results in allocations that comport with the arm's length standard.7 If the taxpayer fails to show that its allocations meet the arm's length standard, then the Court is tasked with determining the arm's length allocation.8 In conducting its abuse of discretion analysis, the Court first dealt with Medtronic US's claim that the Service had abandoned its position. Medtronic US's claim was based on the fact that the Service had originally accepted its CUT methodology in the MOU, and then asserted a CPM methodology in the notice of deficiency. The Court was unpersuaded, noting that the Service had presented the same CPM analysis in its notice of deficiency as it had during arguments at trial, and thus, there had been no abandonment of its position. However, the inquiry was not over, and the Court next turned its attention to Medtronic US's assertion that the Service's failure to give due regard to the importance of quality control also constituted an abuse of discretion. In reviewing the Service's contention that the CPM was the best method under Section 482, the Court presented the details of the economic analysis that served as the basis for the Service's position (the Heimert report). The Court noted that the Heimert report employed a value chain analysis to allocate the appropriate amount of system operating profit to the relevant related parties in the various intercompany transactions at issue, including MPROC. On the issue of quality, the Court listed several "concerns" with the analysis presented in the Heimert report, and noted that because a value chain analysis is not prescribed under the Section 482 regulations,9 it was tasked with conducting a facts and circumstances analysis to determine whether the application of the CPM was arbitrary, capricious or unreasonable. The Court noted that in order for the Heimert report to conclude that MPROC was merely an assembler of finished medical devices, it had to have made some kind of determination as to the role of quality. In other words, either quality was not a success factor at all in the sale of medical devices, or quality was important, but MPROC did not have a role in quality control functions that was more significant than that of any other entity in the value chain. The Service contended that Medtronic US's new product pipeline, successful clinical trials and a well-trained sales force were the critical factors in determining the success of Medtronic US's products. The Court disagreed, and finding factors such as MPROC's robust CAPA program and its role as " … the last line of defense before a potential product quality issue" determinative.10 Accordingly, because MPROC was " … an integral part of [Medtronic US] … [that] not only made the finished product; it made sure that the finished product was safe and could be implanted in the human body,"11 the Heimert report failed to give enough weight to MPROC's quality control function. The Court also took issue with the 14 comparable companies the Heimert report used in its CPM analysis, noting that not all of them were manufacturers of similar devices, and those that did manufacture similar devices did so on a much smaller scale. In addition, many of the comparable companies were engaged in functions in which MPROC was not: sales, R&D, and clinical functions. The Court concluded that the comparables used in the CPM analysis were inconsistent with the Section 482 regulations, due to an insufficient degree of comparability between their functions, assets and risks and those of MPROC. The Court also took issue with the fact that the Heimert report used the same set of comparables to benchmark MPROC's arm's length manufacturing return and Medtronic US's return for the sale of component parts to MPROC, calling into question the reliability of both results. The Heimert report used ROA as the profit level indicator (PLI) in its CPM analysis, which took into account the value of MPROC's buildings, equipment and inventory. However, because the Heimert report calculated ROA estimates based on aggregated financials, it did not look at the value of MPROC as an operation, and thus, did not accurately capture the value attributable to MPROC. Noting that the Section 482 regulations do not require aggregation, but that in some cases it may be appropriate, the Court highlighted Example 4 in Treas. Reg. Section 1.482-5(e), which illustrated aggregation principles for covered transactions similar to those at issue during trial. The Court found that in this case, aggregation did not result in a reasonable arm's length allocation of income to MPROC.12 Taking all of the above conclusions together, the Court concluded that Medtronic US met its burden of proving that the Service's allocations were arbitrary, capricious or unreasonable. On the CWI issue, the Court rejected the Service's contention that Medtronic US had transferred its "crown jewels" to MPROC, and noted that the CWI principle did not require a certain method or a specific range of profits. Accordingly, because the Heimert report's application of the CPM allocated too much profit to Medtronic US, and CWI did not mandate the CPM's application, the Court's determination that the Service's allocations were arbitrary, capricious and unreasonable was undisturbed. Having concluded that the Service's allocations constituted an abuse of discretion, the Court next turned to the inquiry of whether Medtronic US's application of the CUT methodology produced an arm's length result. The Court first noted that Medtronic US's arm's length royalty rates of 29% and 15% of net intercompany sales for devices and leads, respectively, came from several uncontrolled comparables, including the Pacesetter agreement, in which Medtronic US and Siemens agreed to cross-license certain intangibles. However, the Court highlighted differences between the transaction features in the comparable uncontrolled transactions set, and those at issue at trial, including 1) the instant case involved both CRDM and Neuro devices; 2) Medtronic US's expert failed to analyze devices and leads separately when making adjustments to the rates in the Pacesetter agreement;13 3) the Pacesetter agreement included some of the same, but also different, intangibles; and 4) the Pacesetter agreement came about as a result of litigation. As a result, the expert's range of arm's length royalty rates, 0.5% - 20%, was "unconvincing and vague."14 Further, Medtronic US's expert failed to include a profit potential analysis, as is required under the Section 482 regulations. For all of the foregoing reasons, the Court also rejected Medtronic US's method, and found that it had not met its burden of proving that its CUT methodology produced an arm's length result. Having concluded that even though the Service's allocations constituted an abuse of discretion, Medtronic US's methodology also failed to produce an arm's length result, the Court next addressed what an arm's length allocation of profit between MPROC and Medtronic US on the devices and leads licensing agreements should have been. Since neither the Service's nor Medtronic US's method was deemed reasonable, the Court was left to its own devices, as it had " … little help from the parties to determine the proper method."15 The Court rejected the Service's contention that appropriate adjustments could not be made to the Pacesetter agreement. Accordingly, the Court used Medtronic US's expert's adjusted royalty rate of 17% as a starting point, and made several adjustments for know-how, profit potential, and the fact that the Pacesetter agreement only involved CRDM technology, while the devices licenses involved both CRDM and Neuro technology. After making all of the various adjustments, the Court arrived at a wholesale royalty rate of 44% for devices licenses. Further, because the devices business was significantly more profitable than the leads business, the Court concluded that a royalty rate of 22% for leads licenses was reasonable. Finally, the Court acknowledged that its royalty rates were similar to that contained in the Puerto Rico MOU, but characterized the similarity as merely coincidental. Because the Swiss Supply Agreement called for the same terms to which MPROC would have been held had it been the entity to manufacture and sell devices, the Court concluded that the same arm's length royalty rate of 44% should apply to Medtronic Europe. Turning to the 367(d) issue, the Court took exception to the Service's alternative argument, noting that it seemed to be premised upon the idea that if the Court rejected the Service's Section 482 adjustments, it must agree that intangibles had been transferred, since there was no other legitimate explanation for MPROC's high profitability. The Court did not agree, and noted that the Service's own answering brief clearly stated that " … section 367(d) does not apply to the [intellectual property] licensed by MPROC."16 Accordingly, the Court found that the record did not support the conclusion that any intangibles subject to Section 367(d) had been transferred, summarily rejecting the Service's alternative argument.
2 All "Section" references are to the Internal Revenue Code of 1986 and the Regulations promulgated thereunder. 3 Following the announcement of the phase-out of Section 936 benefits, Medtronic US reorganized its existing Puerto Rico operations into MPROC. Specifically, all of the Section 936 possession corporations each contributed substantially all of their operational assets to MPROC in exchange for MPROC stock in a Section 351 transaction. 5 The other three intercompany agreements (a distribution agreement, a trademark licensing agreement, and a component supply agreement) were found to be at arm's length at trial. 9 See id. at 97 (noting that "[t]he Section 482 regulations do not include a description of a value chain approach."). 12 The Court's reasoning on this point is a tautology: "The resulting system profits allocated to MPROC were not reasonable because Heimert allocated an unreasonably small percentage of the profits to MPROC." 13 The Court also took issue with the fact that Medtronic US's expert did not make the appropriate adjustments to account for the material differences between the Pacesetter agreement and the devices and leads agreements until he was on the stand at trial. Document ID: 2016-1072 | |||||||||||||||
