July 18, 2024 IRS and Medtronic file appellate briefs in Eighth Circuit appeal arguing for different transfer pricing methods
The IRS and Medtronic Inc. (Medtronic US) both have filed appellate briefs with the US Court of Appeals for the Eighth Circuit in the long-running Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic) transfer pricing case. In the most recent Tax Court case, the court had applied an "unspecified method" to determine the royalty rate for a license agreement between Medtronic US and its Puerto Rican subsidiary (MPROC) (see Tax Alert 2022-1288).1 The IRS argued in its brief that the Comparable Profits Method (CPM) should have been used for the calculation, while Medtronic US argued that the Comparable Uncontrolled Transaction (CUT) method should have been used. Facts Medtronic US entered into a licensing agreement (the MPROC Agreement) with MPROC to manufacture medical devices. The MPROC Agreement established royalties to be paid by MPROC to Medtronic US for certain intangible property used by MPROC for further development, manufacturing and commercialization of the medical devices. 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 CPM, the IRS concluded that the royalties paid by MPROC were not arm's length and should be increased. In its first decision, the Tax Court rejected the IRS's use of the CPM for multiple reasons. The Tax Court also rejected Medtronic US's application of the CUT method. Medtronic US'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 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 what it considered to be an arm's-length result. (For a detailed explanation of the Tax Court's first decision, see Tax Alert 2016-1072). The IRS appealed to the Eighth Circuit, which vacated the Tax Court's first decision for failing to provide sufficient factual findings and analyses to enable the appellate court to evaluate whether the best pricing method was applied and remanded the case to the Tax Court for reconsideration. (For a detailed explanation of the Eighth Circuit's decision, see Tax Alert 2018-1713). On August 18, 2022, the Tax Court issued its second opinion in Medtronic. Medtronic US and the IRS again proposed to apply the CUT method and CPM respectively, which the Tax Court again rejected. The Tax Court requested that Medtronic US and the IRS propose alternative methods. Medtronic US proposed two versions of a three-step unspecified method that combined elements of the CUT method and CPM with a residual profit split. The IRS declined to propose an alternative method. Ultimately, the Tax Court applied Medtronic US's alternative unspecified method, but derived its own split of the residual profit, resulting in a total system profit split of 69% allocated to Medtronic US and 31% to MPROC, and a wholesale royalty rate of 48.8%. (For a detailed explanation of the Tax Court's second opinion, see Tax Alert 2022-1288). The IRS appealed the second Tax Court decision to the Eighth Circuit and Medtronic US cross-appealed. Cross appeals IRS brief as appellant On December 15, 2023, the IRS filed its opening appellate brief with the Eighth Circuit. The IRS argued that the unspecified method applied by the Tax Court cannot be the best method because the Pacesetter Agreement did not involve comparable intangible property with comparable profit potential and, therefore, cannot be used to price the MPROC Agreement. The IRS asserted that the CPM should be used in pricing Medtronic US's intangibles. The IRS also argued that the Tax Court did not satisfy the mandatory "realistic alternatives" principle because it did not evaluate Medtronic US's reasonable alternatives to allocating 31% of the profit to MPROC for its manufacturing function. Medtronic US's brief as appellee/cross-appellant On February 15, 2024, Medtronic US filed its reply brief with the Eighth Circuit. Medtronic US argued that the Tax Court should apply the CUT method and that the Pacesetter Agreement was a valid CUT. If the Eighth Circuit found that Medtronic US's CUT was not the best method, however, "then the next-best method was the Tax Court's unspecified method utilizing the Pacesetter Agreement and a modified version of the Commissioner's CPM. The regulations permit unspecified methods precisely because it may not always be possible to use the more particular methods." Medtronic US went on to argue that even if the unspecified method was the best method, the Tax Court erred in its allocation of profits (20% to MPROC and 80% to Medtronic US) because it was an "arbitrary numerical division" of remaining profits without any evidence to support it. Medtronic US argued that the Tax Court should at least be required to apply one of Medtronic US's proposed profitability divisions and assign a greater portion of the residual profits to MPROC. IRS answering brief and reply brief as appellant/cross-appellee On April 15, 2024, the IRS filed its answering and reply brief with the Eighth Circuit. The IRS argued that the Tax Court correctly concluded that the CUT method was not the best method to value Medtronic US's intangibles because:
The IRS then argued that the CPM is the only method eligible to be the best method because there is no difference between MPROC and the comparable companies that would preclude applying the CPM. The IRS also reiterated that the Tax Court should have investigated the realistic alternatives available to Medtronic US. In addition, the IRS argued that the Tax Court's application of its own unspecified method to determine Medtronic US's pricing contravened the relevant regulations. Medtronic US's reply brief as appellee/cross-appellant Medtronic US responded to the IRS's April brief by filing a reply brief with the Eighth Circuit on June 6, 2024. Medtronic US argued that using the CPM method is not required or supported by law. Instead, the CUT method is more reliable than the CPM or unspecified method based on the regulations and extensive Tax Court findings. Applying the CUT method, Medtronic US argued that the Pacesetter Agreement is a CUT because it involves the same or comparable intangible property as the MPROC license with similar profit potential. Furthermore, adjustments are a well-accepted feature of transfer pricing and had been made by the Tax Court for "know-how and profit potential." Medtronic US also asserted that the comparable property includes the patents as well as the non-patent intangibles used in connection with the patents. Medtronic US went on to argue that even if the CUT method was not the best method, Medtronic's unspecified method incorporating the direct evidence from the Pacesetter Agreement would be more reliable than the CPM. Implications This case has important consequences not only for the long-standing dispute over transactional versus profit-based methods (e.g., CUT method versus CPM), but also for the application of the unspecified method, which taxpayers may have used due to reliance on the second Tax Court opinion. Taxpayers should closely monitor the outcome of Medtronic and other transfer pricing cases currently working through the courts that deal with similar disputes over the selection of the best method.
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