October 16, 2023
IRS appeals Tax Court's latest decision in Medtronic
The IRS recently appealed the decision issued by the Tax Court in Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic III)1 to the Court of Appeals for the Eighth Circuit. The decision was issued in accordance with the Tax Court's decision on August 18, 2022, which applied an unspecified method to determine the royalty rate for a license agreement between Medtronic Inc. (Medtronic US) and its Puerto Rican subsidiary (MPROC) (see Tax Alert 2022-1288). The basis for the IRS's appeal is not explained in the Notice of Appeal.
In the latest decision, the Tax Court determined deficiencies in income tax for tax years 2005 and 2006 of approximately $175 million, plus interest.
Medtronic US entered into a licensing agreement (the MPROC Agreements) with its Puerto Rican subsidiary (MPROC) to manufacture medical devices (devices and leads). The MPROC Agreement established royalties to be paid by MPROC to Medtronic US for certain intangible assets used by MPROC for further development, manufacturing and commercialization of the medical devices and leads. As part of the MPROC Agreement, MPROC was responsible for bearing product liability expenses associated with the products it manufactured.
Based on an analysis using the Comparable Profits Method (CPM), the IRS concluded that the royalties paid by MPROC were not arm's length and should be increased. In Medtronic I,2 the Tax Court rejected the IRS's use of the CPM for multiple reasons, including (1) failing to give enough weight to MPROC's quality control function; (2) using comparable companies that differed significantly from MPROC by manufacturing dissimilar devices on a smaller scale and engaging in functions in which MPROC did not engage; (3) using a profit level indicator that did not adequately capture the return to certain assets not carried on the MPROC balance sheet; and (4) analyzing certain functions on an aggregate basis that should have been analyzed separately.
The Tax Court also rejected Medtronic US's application of the CUT method. Medtronic's CUT analysis was based on several comparable transactions, including an agreement between Medtronic US and Siemens Pacesetter Inc. (Pacesetter) to cross-license certain intangible property (the Pacesetter Agreement). The Tax Court highlighted various issues that in totality rendered Medtronic US's CUT analysis not the best transfer pricing method, including (1) the MPROC Agreement involved a broader array of devices than the Pacesetter Agreement; (2) differences in the scope and types of intangible property licensed under each agreement; (3) the failure to analyze devices and leads separately when adjusting the royalty rates in the Pacesetter Agreement; (4) the parties entered the Pacesetter Agreement to resolve litigation between the parties; and (5) the failure to include a profit-potential analysis.
The Tax Court, therefore, undertook its own transfer pricing analysis based on the CUT method, using the Pacesetter Agreement as the starting point. The Tax Court made several adjustments to the Pacesetter Agreement to reach an arm's-length result, including adjustments for know-how, profit potential, and differences in the intangible property. The Tax Court concluded that wholesale royalty rates of 44% for devices and 22% for leads were arm's length.
The IRS appealed to the Eighth Circuit in Medtronic II,3 which vacated Medtronic I for failing to provide sufficient factual findings and analyses to enable the appellate court to evaluate whether the best transfer pricing method was applied and remanded the case for reconsideration.
On August 18, 2022, the Tax Court issued its second opinion in Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic III).4 The Tax Court rejected the transfer pricing analysis of both the IRS and Medtronic US and instead applied an unspecified method to determine the royalty rate for a license agreement between Medtronic US and MPROC. The Tax Court increased the royalty rate to 48.8% for devices and leads for years 2005 and 2006.
The Tax Court opinion in Medtronic III has provided guidance for related-party transactions by rejecting the CUT and CPM as the best method and instead applying an unspecified method. Further, when the Eighth Circuit ultimately rules on the IRS's most recent appeal of the Tax Court's decision, it will provide important future precedent.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
1 T.C. Memo. 2022-84 (2022).
2 T.C. Memo. 2016-112 (2016).
3 900 F.3d 610 (8th Cir. 2018).
4 T.C. Memo. 2022-84.