The U.S. District Court for the Western District of Michigan held in Perrigo Co. v. United States, No. 1:17-CV-737 (W.D. Mich. Sept. 25, 2025), that a US company's assignment of the supply and distribution of a generic omeprazole product to an Israeli affiliate had economic substance. Therefore, the IRS should not have reallocated the income to the US company, which is entitled to a refund of the taxes it paid, along with the penalties and interest.

Facts

Perrigo collaborated with Dexcel Pharma, an Israeli drug company, through a domestic affiliate (L. Perrigo Co. (LPC)) to bring a generic omeprazole product to the US market. During this time, Perrigo restructured from a small domestic entity into a major multinational pharmaceutical company under "tax-efficient supply chain management." As part of this process, Perrigo assigned the "Dexcel Supply & Distribution Agreement" from LPC to the Israeli affiliate in November 2006. Perrigo determined an arm's length price of $877,832 based on the cost-plus method, using the comparable profits method to determine the markup on costs that the Israeli affiliate would pay LPC for distribution.

According to the court, Perrigo understood that the Israeli affiliate would have to pay an arm's-length price to LPC for assignment of the agreement and also for LPC's domestic distribution efforts following any successful launch.

During the tax years at issue, Perrigo's omeprazole business via the Dexcel Supply & Distribution Agreement totaled $297.5 million in pre-tax operating profits with a total of $977.4 million in net sales.

Perrigo included the $877,832 received by LPC from the assignment as taxable income in its 2007 tax documents. For tax years 2009 through 2012, the IRS reallocated income from the omeprazole sales from Perrigo's Israeli affiliate to Perrigo's domestic entities. The IRS alleged that Perrigo's assignment of the Dexcel Supply & Distribution Agreement lacked economic substance. Alternatively, the IRS alleged that the assignment was not priced at arm's length under IRC Section 482.

After paying $143 million in taxes, penalties and interest, Perrigo filed claims for refund, which the IRS denied. Perrigo subsequently filed a lawsuit in 2017 alleging that it overpaid its tax, interest and penalty obligations for 2009 through 2012.

Analysis

According to the court, the main issue under both the economic substance doctrine and IRC Section 482 income-reallocation argument is whether there was risk and uncertainty at the time the contract for the assignment was made.

Economic substance doctrine

The court found that, "[w]hether the question is one of economic substance, business purpose, motivation beyond tax avoidance, or command and control of income — the Government's reliance on the doctrines fails under the facts presented at trial."

The court concluded that the bench trial established that Perrigo had a genuine business purpose and motivation — beyond tax-planning — in diversifying and expanding its business internationally to have a more global footprint.

The court rejected the IRS's challenge of the legitimacy of Perrigo's transactions. Under the facts presented at trial, the court found, the entire process demonstrated economic substance and legitimate business purpose. In support of its finding, the court said:

• Credible trial testimony indicated Perrigo was building its international structure contemporaneously with the development of the omeprazole opportunity, not retroactively after success was assured
• Perrigo's slow execution of paperwork and delayed capitalization were found to be results of the early stage of international expansion, not indicators of a sham
• Perrigo retained a professional services firm, identified appropriate opportunities, formed necessary entities, and executed the Dexcel deal, all within the relevant fiscal year
• During this period, Perrigo reasonably believed that FDA approval and patent resolution were still years away and retained the option to pursue its own generic product
• Perrigo finalized transactions quickly, using the infrastructure already in place, once the omeprazole project moved toward launch faster than expected

IRC Section 482

Perrigo's and the IRS's experts agreed that the best method under IRC Section 482 was a discounted cash flow (DCF) method. However, they disagreed over the inputs that apply to the DCF method. According to the court, "[d]istilled down, these disagreements come down to (1) the date the assignment is deemed to have occurred; (2) the use of projections vs actual results to determine both (a) cash flow and (b) the percentage of sales used to reimburse [LPC] for its distribution related expenses; and (3) the application of a differential discount rate to convert the lump-sum DCF value into an equivalent royalty rate."

The first step in the IRC Section 482 analysis, the court said, is determining when the assignment took place. The court found that Perrigo was correct in arguing that the first step occurred on November 29, 2006, because Perrigo assumed the risks of the Dexcel omeprazole product and the potential upsides at that point in time. The fact that the final paperwork was completed later in the same fiscal year did not change this conclusion, the court said.

The next step, the court said, is determining cash flows, which primarily entails looking at sales and costs of sales.

The court said it did not agree with the IRS's use of ex-post sales data in the arm's-length analysis, adding that Perrigo's contemporaneous projections were the correct ones to use in the analysis.

Perrigo's expert proposed "Scenario A" and "Scenario B" to determine the arm's-length pricing. In Scenario A, the expert assumed the pricing was not arm's length and applied a reduced profit margin for LPC's distribution activities, which resulted in a lump-sum payment of approximately $43.1 million or an equivalent royalty rate of 6.04%. In Scenario B, the expert assumed the pricing was arm's length and calculated the price for the Israeli affiliate's expected profits as a lump-sum net present value of $37.4 million or an equivalent royalty rate of 5.24%.

The court accepted the framework of Scenario B but rejected certain profit elements and applied its own adjustments, specifically using a 5% sales, general and administrative expense rate and a 10% discount rate, to ensure the royalty rate accurately reflected economic realities and arm's length standards.

The court rejected all proposed accuracy-related and valuation misstatement penalties, citing Perrigo's good faith reliance on its advisor and the use of recognized transfer pricing methods. The court asked the parties to submit a proposed final judgment consistent with the court's rulings and changes to the amounts within 30 days.

Patent litigation expenses

The court found for Perrigo on its argument that it was entitled to deduct its IRC Section 271(e)(2) patent litigation expenses as ordinary and necessary business expenses. The court distinguished between FDA regulatory approval and patent litigation, concluding that defense costs under 35 U.S.C. Section 271(e)(2) are ordinary and necessary business expenses under IRC Section 162.

Implications

While the IRS has signaled that it can apply the economic substance doctrine to transfer pricing cases (see Tax Alert 2024-2345), Perrigo is the first transfer pricing case designated for litigation where the IRS has done so. The court's rejection of the IRS's approach confirms that, particularly for transfers of intangibles, taxpayers with genuine business purpose aligned with appropriate risk assumption can withstand such challenges.

By reaffirming the determination of arm's-length pricing using ex ante projections rather than ex post results, the court underscored the importance of contemporaneous financial models. Its acceptance of Perrigo's DCF-based analysis with adjustments also signals that reasonable methods will be respected, but key assumptions must reflect economic reality.

Finally, the court's denial of the IRS's asserted penalties emphasizes the protection afforded by good-faith reliance on advisors and recognized transfer pricing methods.