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August 25, 2022
US Tax Court increases Medtronic royalty rate under unspecified method
On 18 August 2022, the United States (US) Tax Court issued its second opinion in Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic III).1 In this opinion, the Tax Court rejected the principal transfer pricing analysis of both the Internal Revenue Service (IRS) and Medtronic Inc. (Medtronic US), instead applying an unspecified method proposed in the alternative by Medtronic to determine the royalty rate for license agreements between Medtronic US and its Puerto Rican subsidiary (MPROC). Using this method, the Tax Court increased the wholesale royalty rate to 48.8% for devices and leads for years 2005 and 2006.
This decision comes after the Eighth Circuit Court of Appeals vacated the Tax Court's first opinion in Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner (Medtronic I).2 The Eighth Circuit, in Medtronic II,3 had concluded that the Tax Court failed to provide sufficient factual findings to enable the appeals court to evaluate the Tax Court's determination of the best transfer pricing method. As a result, the Eighth Circuit remanded the case to the Tax Court to make those findings.
Medtronic US is the parent company of a global medical device company that manufactures and sells implantable medical devices. Medtronic US entered into licensing agreements (the MPROC Agreements) with its Puerto Rican subsidiary (MPROC) to manufacture medical devices (devices and leads). The MPROC Agreements 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 Agreements, 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 Medtronic I, 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 a number of 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 Agreements involved a broader array of devices than Medtronic's comparable transactions; (2) differences in the scope and types of intangible property licensed under the agreements; (3) the failure to analyze devices and leads separately when making adjustments to the royalty rates in the agreements; and (4) the failure to include a profit-potential analysis.
The Tax Court, therefore, undertook its own transfer pricing analysis using the Pacesetter Agreement as the basis for its own CUT method. The Tax Court made several adjustments to the Pacesetter Agreement in an effort to reach an arm's-length result, including adjustments for know-how, profit potential and differences in intangible property. Ultimately, the Tax Court in Medtronic I 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, which vacated Medtronic I for failing to provide sufficient factual findings and analyses to enable the appeals court to evaluate whether the best transfer pricing method was applied, and remanded the case to the Tax Court.
Detailed discussion of Medtronic III
Like in Medtronic I, Medtronic US argued the CUT method was the best method and that the Pacesetter Agreement was a valid CUT. The Tax Court evaluated the Pacesetter Agreement using the general comparability factors listed in Treas. Reg. Section 1.482-1(d)(1) and focused specifically on three factors: (1) functions, (2) economic conditions and (3) property or services. The Tax Court concluded that the Pacesetter Agreement did not meet the three factors and therefore was not a CUT. The Tax Court further held that the CUT method was not the best transfer pricing method.
Regarding functions, the Tax Court noted that there were significant differences between the functions performed by the parties under the MPROC Agreements and the Pacesetter Agreement. Medtronic US, as licensor, performed research and development (R&D) and business management functions under the MPROC Agreements and MPROC operated solely as a manufacturer of finished goods. In contrast, Medtronic US did not perform either function under the Pacesetter Agreement, while Pacesetter, as licensee, performed R&D, component manufacturing and distribution.
With respect to economic conditions, the Tax Court disagreed with the IRS that the agreements were not comparable because of the parties' different relationships (i.e., the Pacesetter Agreement created a "horizontal" relationship between competitors whereas the MPROC Agreements created a "vertical" relationship between a corporation and its subsidiary). The Tax Court, however, ultimately concluded that, because of the significant difference in profit potential between the MPROC Agreements and the Pacesetter Agreement (MPROC's product profit margin being nearly double that of Pacesetter's, according to an IRS expert), the economic conditions were not comparable.
With respect to similarity of property, the Tax Court determined that the licensed products were not comparable, focusing in particular on the scope and types of intangible property licensed under each agreement. The intangible property licensed under the MPROC Agreements included secret processes, technical information, technical expertise relating to the design of devices and leads, and all legal rights including know-how, which were not part of the Pacesetter Agreement. Additionally, the total number of patents available to MPROC under the licenses was 1,800 in 2006, whereas the Pacesetter Agreement included only 342 patents.
While the Tax Court found that the Pacesetter Agreement was reached "in the ordinary course of business," notwithstanding being the product of settlement negotiations to resolve litigation,4 the Tax Court concluded that too many adjustments would be required to use the Pacesetter Agreement and reliably apply the CUT method. At the same time, however, the Tax Court noted that "there are enough similarities that the Pacesetter Agreement can be used as a starting point for determining a proper royalty rate."5
The IRS proposed the CPM as the best method and the Tax Court rejected it — again — on multiple grounds. The Tax Court held that MPROC's manufacturing activities were not "routine," as the IRS argued, but rather were sophisticated manufacturing operations using a highly trained workforce to produce lifesaving, Class III medical devices in an industry where quality is of the utmost importance.
The Tax Court also found that the IRS's CPM analysis did not adequately compensate MPROC for its important product quality control activities and for assuming significant product liability risk. While the IRS argued that MPROC did not bear all product liability risk for the products it manufactured, this was contradicted by the language in the MPROC Agreements. Further, the transfer pricing regulations state that risks agreed to in writing will be respected so long as the risks are consistent with the economic substance of the transaction. Because MPROC had financial capacity to bear the risk and had exercised "managerial and operational control over the manufacturing operations," the Tax Court respected MPROC's risk assumption.6
To compensate for the assumption of risk, the IRS proposed an adjustment to the CPM of US$25 million per year (dollar references in this Alert are to the US$). The Tax Court examined the costs from two previous product recalls, one costing MPROC $117 million and the other $271 million, to determine the actual cost for the liability MPROC assumed. Due to the disparity between previous costs and the proposed adjustment, the Tax Court concluded that the IRS's proposed adjustment was insufficient to accurately account for MPROC's assumption of risk in a CPM analysis.
The Tax Court also determined that the IRS's CPM companies were again not comparable to MPROC. While MPROC manufactured the riskiest type of medical device product — Class III — the IRS's CPM companies manufactured Classes I, II and III medical devices. To address this concern, the IRS proposed a "modified CPM" consisting of a subset of the comparable companies that manufacture Class III devices. However, none of the IRS's selected comparables manufactured similar cardio or neuro devices and each performed functions in addition to finished device manufacturing. Finally, based on revenue and operating assets, none of the comparables were a business of similar size to MPROC.
In summary, the Tax Court stated that the companies selected by the IRS were not sufficiently similar to MPROC because they had "fundamentally different asset bases and involve[d] different functions and risks from those of a class III medical device manufacturer."7 Accordingly, like in Medtronic I, the Tax Court again held that the IRS's approach constituted an abuse of discretion and rejected the CPM as the best method to price the royalties payable under the MPROC Agreements.
The Tax Court requested that Medtronic US and the IRS propose alternative methods after rejecting both Medtronic's CUT methods and the IRS's CPM as the best method. Medtronic US proposed two versions of an unspecified method combining elements of the CUT method and the CPM. Each version consisted of three steps. Steps 1 and 2 in each version were the same. The IRS did not propose an alternative method and reiterated using the CPM as the best method.
Step 1 was a modified CUT, using the Pacesetter Agreement to allocate profit to Medtronic US for its R&D activities. Because the payment terms were comparable and had running royalty rates based on sales of devices and leads, the Tax Court agreed that the Pacesetter Agreement, although not a CUT, was an adequate starting point to determine an arm's-length royalty rate. After considering expert testimony, the Tax Court also concluded that the royalty rates for devices and leads should be the same. Using a base retail royalty rate of 7% from the Pacesetter Agreement, plus certain adjustments, the Tax Court determined that a 17.3% royalty rate was reasonable, resulting in income of $674.4 million allocated to Medtronic US.
Step 2 was a modified CPM. Initially, this second step made an upward adjustment for asset intensity to MPROC's operating assets to allow for a more reliable comparison of MPROC's assets to the IRS CPM companies. The Tax Court noted that the median operating asset intensity for the IRS's five comparables was 52%, whereas the asset intensity percentage for MPROC was 13.3%. Accordingly, Medtronic US applied an upward adjustment to increase MPROC's operating asset base.
After adjusting for asset intensity, step two allocated profits to MPROC based on a 41.3% return on assets (ROA) (the average ROA for the five companies used in the IRS's modified CPM analysis), resulting in income of $1.3 billion allocated to MPROC. This amount was reduced to account for returns earned by Medtronic US subsidiaries for component manufacturing (i.e., $138.8 million) and distribution (i.e., $425.7 million).
After Steps 1 and 2, the remaining profit to allocate was $1.3 billion. Medtronic US proposed two residual profit splits in Step 3: (i) 65% (MPROC) / 35% (Medtronic US), resulting in a total system profit of 51% allocated to Medtronic US and 49% to MPROC, and a wholesale royalty rate of 35.7%; and (ii) 50% (Medtronic US) / 50% (MPROC), resulting in a total system profit of 57% allocated to Medtronic US and 43% to MPROC, and a wholesale royalty rate of 40%.
Ultimately, the Tax Court used Medtronic's alternative unspecified method, but selected an 80% (Medtronic US) / 20% (MPROC) split of the residual profit in Step 3, 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%. According to the Tax Court, the rationale for the 80% / 20% split was to reconcile imperfections in both the modified CUT in Step 1 (i.e., only one comparable, differences in profit potential, inherent difficulties making further adjustments to the Pacesetter Agreement) and the modified CPM in Step 2 (i.e., inadequacies of the comparables, "unrealistic profit allocation to MPROC,"8 an arguably too-high asset intensity adjustment). While noting that the "solution may not be perfect," the Tax Court indicated that the allocation of residual profit in Step 3 could be used to rectify these issues.9 In accepting the unspecified method as the best method, however, the Tax Court pointed out that its approach was "not an attempt to create a new method which is simply a hybrid of the CUT method and the CPM."10
The Tax Court's opinion in Medtronic III provides guidance for future related-party transactions. Transfer pricing cases are inherently factual, and each case stands on its own facts. The Tax Court's opinion shows that the Tax Court may utilize an unspecified method if the court determines that it is the most reliable method. The Tax Court gave credence to the industry-specific value of the products manufactured and the management of the risk.
Additionally, the Tax Court's analysis closely followed the comparability framework set forth in the transfer pricing regulations. When using a CUT method, the case indicates that courts will closely consider all facts and circumstances within the comparables when reviewing related-party relationships. In the wake of Medtronic III, taxpayers should put continued emphasis on best method selection and expect that the IRS will likely evaluate alternative methodologies.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transactions Services, Transfer Pricing, Washington, DC
Ernst & Young LLP (United States), International Tax and Transactions Services, Transfer Pricing (East Region)