The Eighth Circuit vacated the Tax Court's order in the long-running Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic US) transfer pricing case and remanded the case to the Tax Court for further proceedings.¹ The Eighth Circuit held that the CUT method, advocated by Medtronic US, is not the best method to determine the arm's-length royalty rate when the uncontrolled transaction does not transfer comparable intangible rights and does not have similar profit potential. Instead, the Eighth Circuit agreed with the IRS that the CPM is preferable but directed the Tax Court to conduct additional fact finding to determine whether reliable adjustments can be made.

Background

In 2002, Medtronic US granted Medtronic Puerto Rico (MPROC) the exclusive right to use intangible property to manufacture and sell certain medical devices in exchange for royalties based on net sales (the MPROC Agreement). Medtronic US applied the CUT method to determine the royalty rates. The IRS issued a notice of deficiency with respect to Medtronic US's 2005 and 2006 tax years; it applied a CPM to determine its adjustments. In its first decision, the Tax Court rejected both the IRS's use of the CPM and Medtronic's application of the CUT method and instead applied its own version of the CUT method. (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 opinion and remanded the case to the Tax Court for reconsideration. (For a detailed explanation of the Eighth Circuit's first opinion, see Tax Alert 2018-1713).

On remand, the Tax Court again rejected proposals from Medtronic US and the IRS to apply the CUT method and CPM respectively. The Tax Court requested that Medtronic US and the IRS propose alternative methods. Medtronic US responded by proposing two versions of a three-step unspecified method that combined elements of the CUT method and CPM with a residual profit split, while the IRS declined to propose an alternative method.

The Tax Court subsequently adopted Medtronic US's three-step unspecified method, with some modifications. This resulted in a wholesale royalty rate of 48.8%, with an overall profit split of approximately 69% to Medtronic US and 31% to MPROC. (For a detailed explanation of the Tax Court's second opinion, see Tax Alert 2022-1288).

The IRS appealed the second Tax Court opinion to the Eighth Circuit and Medtronic US cross-appealed. (For details on the briefs, see Tax Alert 2024-1399).

Court analysis

In its latest ruling, the Eighth Circuit rejected the Tax Court's use of an unspecified method to determine the royalty rate. It also agreed with the IRS that the CUT method was not the best method to determine an arm's-length royalty rate for the MPROC Agreement due to differences in the intangible property and profit potential between the MPROC Agreement² and a cross-licensing agreement between Medtronic US and Siemens Pacesetter Inc. (the Pacesetter Agreement). The Pacesetter Agreement covered only patents, while the MPROC Agreement included patents, know-how, regulatory approvals, and other valuable intangibles. As such, the Eight Circuit concluded that the CUT method, which relies on comparability between agreements, could not reliably establish arm's-length royalty rates for the MPROC Agreement.

Additionally, the Eighth Circuit criticized the Tax Court's rejection of the IRS's CPM, stating that the Tax Court had applied an overly strict standard regarding product similarity and failed to make sufficient factual findings on asset base differences, functional comparability and product liability risk. The Eighth Circuit emphasized that the CPM does not require identical products and that the regulations allow taxpayers to adjust for differences in functions and risks. It also took issue with the Tax Court's conclusion that a group of companies, proposed as comparable by the Tax Court, should be rejected based on fundamentally different asset bases; the Eight Circuit suggested the Tax Court should have instead made findings establishing what those differences were, what effect they had on the profit allocation to MPROC, and whether adjustments could be made to reliably account for any material differences.

Decision

The Eighth Circuit vacated the Tax Court's order and remanded the case for further proceedings. The Eighth Circuit said that, on remand, the Tax Court should:

• Consider whether the proposed comparable companies were "sufficiently similar" to MPROC and, if not, whether adjustments can be made to account reliably for any significant differences
• Make specific findings on asset base differences, functional comparability and product liability risk
• Assess whether Medtronic could have realistically replaced its Puerto Rico subsidiary with another facility, and the associated costs and feasibility
• Reconsider the profit allocation to MPROC in light of the new findings

Implications

The Eighth Circuit's opinion highlights the necessity of thorough fact-finding and clearly documented economic support when defending transfer pricing positions. Taxpayers relying on the CUT method must ensure that their comparables accurately reflect comparable intangible property and similar profit potential, as some courts may be inclined to favor the CPM when comparables are not sufficiently similar or when adjustments are not well-supported. Taxpayers with intercompany licensing arrangements should carefully review their transfer pricing methodologies, paying particular attention to asset base, functional comparability and risk allocation.

Advisors and practitioners should prepare for increased scrutiny of transfer pricing methods and comparables selection, anticipating requests for detailed supporting evidence. The Eighth Circuit's opinion could also affect IRS audits if the IRS places a greater focus on the CPM and the reliability of adjustments.