Judgment summary
This appeal concerns the amount of income Medtronic's 2005 and 2006 consolidated tax returns attributed to its subsidiary, Medtronic Puerto Rico, under intercompany Technology Licenses for intangible property used to manufacture cardiac and neurostimulation devices and leads.
The case had previously been decided by the Tax Court, appealed to the Eighth Circuit in Medtronic I, 900 F.3d 610 (8th Cir. 2018), and remanded for additional fact findings on whether the best transfer pricing method had been applied. On remand, the Tax Court rejected both parties' preferred methods and instead applied a three-step unspecified method, determining a wholesale royalty rate of 48.8% for both devices and leads, and an overall profit split of 68.7% to Medtronic US/Med USA and 31.3% to Medtronic Puerto Rico (paras referenced in judgment).
The Commissioner appealed, challenging the rejection of his proposed comparable profits method and the adoption of the unspecified method. Medtronic cross-appealed, challenging the rejection of its comparable uncontrolled transaction method based on the Pacesetter Agreement, and alternatively sought reconsideration of adjustments under the unspecified method.
The Eighth Circuit vacated the Tax Court's order and remanded again for further proceedings.
Background
Medtronic is a medical device company producing class III devices, including implantable cardiac rhythm stimulation and neurostimulation devices and connecting leads. Medtronic US and its distributor Med USA are located in Minnesota, and its manufacturer, Medtronic Puerto Rico Operations Co., is located in Puerto Rico.
Medtronic allocates profit among these entities through intercompany licensing agreements, referred to as the Technology Licenses, under which Medtronic US granted Medtronic Puerto Rico the exclusive right to use intangible property to manufacture and sell devices and leads, in exchange for a royalty based on net sales to Medtronic US.
The dispute traces back to Medtronic's 2002 return, which used the comparable uncontrolled transaction method, and a subsequent memorandum of understanding setting wholesale royalty rates of 44% for devices and 26% for leads, producing a profit split of approximately 55.6% to Medtronic US/Med USA and 44.4% to Medtronic Puerto Rico.
For the 2005 and 2006 tax years, the IRS determined that the comparable profits method was the best method and assessed a tax deficiency. Medtronic challenged this in the Tax Court, which after trial adopted a modified comparable uncontrolled transaction method using a Siemens Pacesetter patent-licensing agreement, setting royalty rates of 44% for devices and 22% for leads (profit split 54.1%/45.9%), and found a 2005 deficiency and a 2006 overpayment. The Commissioner appealed, and in Medtronic I the Eighth Circuit vacated and remanded for further fact findings on the best method and on comparability of the Pacesetter Agreement.
Core dispute
On remand, Medtronic continued to argue that a comparable uncontrolled transaction method based on the Pacesetter Agreement was the best method to determine an arm's length royalty for the Technology Licenses. The Commissioner argued that a modified comparable profits method, relying on five comparable companies, was the best method. Medtronic alternatively proposed a three-step unspecified method combining elements of both approaches and allocating residual profits between Medtronic US and Medtronic Puerto Rico.
The Tax Court rejected both parties' preferred methods and adopted the three-step unspecified method with adjustments, resulting in a 48.8% wholesale royalty rate for both devices and leads and a profit split of 68.7% to Medtronic US/Med USA and 31.3% to Medtronic Puerto Rico.
The Commissioner appealed, arguing that the Tax Court erred in rejecting his comparable profits method and in adopting an unspecified method that used the Pacesetter Agreement, which he contended was legally impermissible. Medtronic cross-appealed, arguing that the Tax Court clearly erred in finding the Pacesetter Agreement not comparable, or alternatively sought remand for reconsideration of the step-three adjustments under the unspecified method.
Court findings
The Eighth Circuit held that the Tax Court did not clearly err in finding that the Pacesetter Agreement and the Technology Licenses did not involve intangible property with similar profit potential, noting the Commissioner's expert's comparison of a 29% average product profit margin under the Pacesetter Agreement (1993-1995) against a 54% average margin under the Technology Licenses (2005-2006), and the difference between a bare patent licence and the 'full array' of intangible property (patents, know-how, regulatory approvals, secret processes, technical information and copyrights) licensed under the Technology Licenses. Accordingly, the comparable uncontrolled transaction method based on the Pacesetter Agreement was not the best method.
The court held that the Tax Court erred in using the Pacesetter Agreement as a 'starting point' under an unspecified method, because 26 C.F.R. § 1.482-4(c)(2)(iii)(B)(1)(ii) requires similar profit potential for data to be considered reliable, and the Pacesetter Agreement failed that requirement.
The court further held that the Tax Court applied an incorrect legal standard in rejecting the Commissioner's comparable profits method solely because the proposed comparable companies did not make solely class III devices, since the comparable profits method is less dependent on product similarity than other methods under 26 C.F.R. § 1.482-5(c)(2)(iii).
The court found that the Tax Court failed to make sufficient findings regarding the asserted differences in asset bases between Medtronic Puerto Rico and the proposed comparable companies, the effect of any such differences, and whether adjustments could be made. It similarly found the rejection based on 'different functions' insufficient, since functional differences are often reflected in operating expenses rather than rendering the method unreliable.
The court held that the Tax Court did not resolve the factual dispute over the amount of product liability risk borne by Medtronic Puerto Rico in 2005 and 2006 (the Commissioner's expert valued this at around $25 million, Medtronic's expert at $220-235 million, with prior recall costs ranging from $117 million to $324 million), and made no finding on whether any difference in risk borne by the comparable companies was material.
Finally, the court found the Tax Court made no findings on the time and cost Medtronic would need to replicate Medtronic Puerto Rico's manufacturing role at a different facility, which was necessary to assess whether this was a realistic alternative to the Technology Licenses.
Outcome
The Eighth Circuit vacated the Tax Court's order and remanded the case for further proceedings consistent with its opinion, directing the Tax Court to reconsider the comparable profits method under the correct legal standard, make further findings on asset bases, functional differences, product liability risk, and the feasibility of replicating Medtronic Puerto Rico's manufacturing function, and to reassess the arm's length royalty rate and profit allocation accordingly.
Tp method highlighted
The judgment discusses three transfer pricing methods under 26 C.F.R. § 1.482-4(a): the comparable uncontrolled transaction method, the comparable profits method, and unspecified methods, all subject to the 'best method' requirement of finding the method that provides the most reliable measure of an arm's length result.
Medtronic favoured the comparable uncontrolled transaction method, based on a patent-licensing agreement between Medtronic US and Siemens Pacesetter (the Pacesetter Agreement), which the Tax Court and the Eighth Circuit found did not involve intangible property with similar profit potential to the Technology Licenses, and was therefore not comparable.
The Commissioner favoured a modified comparable profits method, using five comparable companies and a return-on-assets profit level indicator, with an adjustment for product liability risk, proposing an allocation of 12-14% of profit from devices and leads to Medtronic Puerto Rico. The Tax Court rejected this method based on product, asset-base, and functional dissimilarities and disagreement over the risk adjustment.
The Tax Court instead applied Medtronic's proposed three-step unspecified method: step one used a modified Pacesetter Agreement-based comparable uncontrolled transaction approach as a 'starting point' to price Medtronic US's research and development; step two applied a modified comparable profits method to allocate profit to Medtronic Puerto Rico's finished-device manufacturing; and step three split the remaining profit between Medtronic US and Medtronic Puerto Rico, yielding a 48.8% wholesale royalty rate for both devices and leads.
Major issues / areas of contention
- Whether the comparable uncontrolled transaction method, based on the Pacesetter Agreement, is the best method for pricing the Technology Licenses between Medtronic US and Medtronic Puerto Rico.
- Whether the intangible property licensed under the Pacesetter Agreement and the Technology Licenses have similar profit potential as required by 26 C.F.R. § 1.482-4(c)(2)(iii)(B)(1)(ii).
- Whether the Tax Court could use the Pacesetter Agreement as a 'starting point' under an unspecified transfer pricing method despite it failing the similar profit potential requirement.
- Whether the Commissioner's proposed comparable profits method was properly rejected on the basis that the comparable companies did not make solely class III medical devices.
- Whether the Tax Court made sufficient findings regarding differences in asset bases, functions, and product liability risk between Medtronic Puerto Rico and the proposed comparable companies.
- Whether the Tax Court made sufficient findings on the time and cost required to replicate Medtronic Puerto Rico's manufacturing function as a realistic alternative to the Technology Licenses.
- Whether the Tax Court's three-step unspecified method, combining elements of the comparable uncontrolled transaction method and the comparable profits method, was properly applied.