Taxpayer Wins Big in Transfer-Pricing Dispute

The Tax Court held that the IRS had abused its discretion in reallocating income related to intercompany licenses for the intangible property required to manufacture certain cardiac and neurological implantable medical devices from a Puerto Rican company to its U.S. parent company.

Background

Medtronic Inc. (Medtronic) is a large medical technology company based in the United States with worldwide operations and sales. It operates in more than 120 countries and has over 33,000 employees. The company has multiple business units that make a wide range of products, including a cardiac rhythm disease management (CRDM) unit and a neurological (Neuro) unit. Among the products these two units make are various medical device pulse generators (devices) and physical therapy delivery units (leads). These two types of medical products are classified by the Food and Drug Administration as Class III medical devices because they are life-supporting or life-sustaining. In the years in question, Medtronic was the dominant company in the market for both CRDM and Neuro devices and leads.

Medtronic US: Medtronic US is the headquarters of Medtronic’s CRDM and Neuro businesses and is responsible for research and development for new and existing products (including devices and leads) and meeting global regulatory requirements for them. Medtronic US also manufactured components for devices and leads through several vertically integrated component manufacturing branches. Its subsidiary, Medtronic Puerto Rico Operations Co. (MPROC), purchased and used some of these components to manufacture devices and leads and sold some of the devices and leads it manufactured to Med USA, another Medtronic US subsidiary, which sold them in the United States and other jurisdictions.

MPROC: Medtronic initially set up two companies in Puerto Rico in the 1970s to take advantage of the favorable Sec. 936 possession corporation rules. After Congress announced the phaseout of Sec. 936 benefits, Medtronic US reorganized the Puerto Rican companies into MPROC, a branch of Medtronic Holding Switzerland GmbH, a controlled foreign corporation. MPROC received an industrial tax exemption from Puerto Rico, which provided that income from certain products of the company was not subject to Puerto Rican income tax. Having this exemption meant that the company paid no tax to Puerto Rico on the income from its CRDM and Neuro products.

MPROC’s devices and leads operations were FDA-registered facilities that manufactured Class III finished medical devices. However, the company did far more than simply put together components from Medtronic US, and its operations were substantially autonomous from Medtronic US. MPROC was separately responsible for its own operations, developed its own IT systems that improved product quality, provided training for physicians, designed and reviewed its manufacturing processes, and otherwise was involved in every aspect of the manufacturing process for leads and devices. Because the lives of patients who received a lead or device the company produced literally depended on their functioning properly, quality control was of extremely high importance in its manufacturing process.

License agreements: Medtronic US and MPROC entered into license agreements, effective as of Sept. 30, 2001, for the intangible property used in manufacturing devices and leads. Under the devices and leads licenses, MPROC obtained the exclusive right to use, develop, and enjoy the intangible property used in manufacturing devices for sale to customers in the United States and its territories and possessions, and leads for sale to customers worldwide. The licenses included a quality-control clause that required MPROC to meet certain standards and specifications and to correct any failures to do so at its own expense. The licenses initially specified a 29% royalty rate on devices and a 15% royalty on leads. As discussed below, the rates were amended to 44% and 26% to satisfy a memorandum of understanding (MOU) between Medtronic and the IRS.

2002 return audit and MOU: In auditing Medtronic’s 2002 tax return, the IRS analyzed the intercompany transactions and the transfer prices among MPROC, Medtronic US, and Med USA. Medtronic used the comparable uncontrolled transactions (CUT) method (one of the four general methods allowed under Regs. Sec. 1.482-4(a) to allocate income from a transfer of intangible property) to determine the arm’s-length royalty rates under the licenses.

The IRS agreed with the transactions identified by Medtronic as comparable transactions for purposes of applying the CUT method, but not with the results Medtronic obtained using the 29% and 15% royalty rates for devices and leads. Eventually, the IRS and Medtronic agreed in an MOU that the royalty rates should be 44% and 26%. To comply with the MOU, Medtronic used the MOU royalty rates in calculating the arm’s-length amounts for the intercompany sales of devices and leads on its 2005 and 2006 returns.

Audits of 2005 and 2006 returns: In its audits of Medtronic’s 2005 and 2006 returns, the IRS initially claimed that it was adhering to the MOU royalty rates in determining how to allocate the income from the intercompany sales of devices and leads, but it nonetheless came up with proposed adjustments related to those sales of over $500 million for 2005 and 2006. Medtronic appealed the IRS’s determination administratively, and the Appeals office sent the case back to Examination for a second look. In the second audit, the IRS abandoned the CUT method and the MOU rates and recalculated the deficiencies based on a report by an expert who used the comparable profits method (CPM), another of the methods allowed under Regs. Sec. 1.482-4(a).

As part of the CPM, the IRS’s expert used a value-chain analysis, which segments a company’s operations into functional activities, allowing qualitative assessment of each participant’s economic contributions to the profits of the consolidated enterprise. Here, the value chain for Medtronic’s CRDM and Neuro leads and devices was MPROC, Medtronic US, and Med USA. The report contended that Medtronic US and Med USA performed most of the functions of the CRDM and Neuro value chain and bore the risks related to the functions they performed, which were related to the overall CRDM and Neuro businesses. According to the IRS, MPROC performed only the final manufacturing steps, which were completed according to processes approved by Medtronic US. Thus, the report concluded that Medtronic had vastly overstated MPROC’s profits.

Based on the report, the IRS issued a notice of deficiency, which made Sec. 482 adjustments resulting in total deficiencies for 2005 and 2006 of almost $1 billion, mainly attributable to the transfer-pricing issue. Medtronic challenged the IRS’s determination in Tax Court.

The Parties’ Positions

Medtronic asserted that the IRS actions were arbitrary and capricious and an abuse of discretion for two reasons. First, the company contended that the position the IRS argued at trial was different from the position it took in the notice of deficiency. Second, the company contended that the IRS abused its discretion in determining its Sec. 482 allocations by not adequately considering the importance of product quality to the success of a manufacturer in the implantable medical device industry and that MPROC, as the manufacturer, was ultimately responsible for the Class III finished medical devices it produced.

Medtronic further contended that the CUT method it had originally used was appropriate and that, using the CUT method, the proper arm’s-length royalty rates were the rates it had used before the MOU: 29% for devices and 15% for leads. The company presented expert testimony that supported these rates. Based on these lowered royalty rates, Medtronic argued that it had made overpayments of almost $600 million for 2005 and 2006.

The IRS maintained that the CPM was the best method to determine the arm’s-length royalty rates on the intercompany sales of devices and leads because Medtronic US and Med USA performed all but one of the economically significant functions for CRDM and Neuro. According to the IRS, the only economically significant function that MPROC performed was assembling finished products, with Medtronic US providing significant oversight and help. With respect to Medtronic’s arguments in favor of the CUT method, the IRS countered that quality was not the most important determinant of success in the medical device industry and that the uncontrolled license arrangements cited by Medtronic’s experts were not comparable to the Medtronic US-MPROC royalty agreement.

The Tax Court’s Decision

The Tax Court held that the IRS’s Sec. 482 allocation of the income from the devices and leads license agreements between Medtronic US and MPROC was arbitrary, capricious, or unreasonable, and thus the IRS had abused its discretion. However, the court also determined that Medtronic had failed to prove that the royalty rates for the devices and leads licenses it used to apply the CUT method were correct and, based on the evidence before it, came up with its own royalty rates to use in applying the CUT method.

Change in position: Medtronic first argued that the IRS had abused its discretion by changing its position regarding the transactions and the correct method for determining whether the transactions were arm’s-length, pointing to differences in the IRS’s position in the MOU and in its arguments to the Tax Court. The Tax Court found that the IRS’s position in the notice of deficiency and its arguments at trial were both based on the same report by the IRS’s expert, and the IRS was not bound by positions (in this case, its position in the MOU) it had taken in previous years. Consequently, the IRS had not abused its discretion by changing its position.

The IRS’s income allocations: Although Regs. Sec. 1.482-4 allows a taxpayer to use one of four methods to allocate income from intangible transfers, in a controlled transaction, Regs. Sec. 1.482-1(c) requires that the taxpayer use the method, based on the facts and circumstances, that provides the most reliable measure of an arm’s-length result (the best method). The IRS asserted that the method used by its expert was the best method.

To determine whether the IRS’s expert used the best method in his analysis, the court looked primarily at the facts and circumstances of the devices and leads licensing agreements between MPROC and Medtronic US. The court found that the expert’s analysis was flawed because he did not properly account for the importance of quality to a successful company in the implantable medical device industry. It also found that the expert’s analysis was dismissive of MPROC’s general role in the production of devices and leads and of Medtronic’s CRDM and Neuro business units and MPROC’s role in quality in particular. According to the court, because the expert’s analysis ignored the fact that quality assurance was vital to MPROC’s role, his conclusion was not supported by the evidence. Thus, the court held that the IRS’s allocations of the income from those agreements, which were based on the expert’s report, were arbitrary, capricious, or unreasonable.

Medtronic argued that the most important factor for its success and profits in manufacturing and selling devices and leads (and in the implantable medical device industry as a whole) is the quality of the products produced. The IRS countered that quality was not the most important factor to Medtronic; rather, Medtronic’s growth was driven by its increased product offerings, by successful clinical trials, and by the size and quality of its sales force. The court sided with Medtronic, citing numerous examples of situations (involving both Medtronic and other manufacturers) where a product recall due to a quality issue had extremely deleterious effects on the fortunes of the company experiencing the recall. The court observed: “A company can have a strong sales force and a creative marketing department, but these will not make a difference if the underlying product is unsafe and ineffective.”

Regarding MPROC’s role in the production of CRDM and Neuro devices and leads, the IRS argued that MPROC was not in any way special and that the company was a mere components manufacturer that acted entirely under the direction and control of Medtronic US. Consistent with this argument, the IRS asserted that MPROC did not play a special role in quality for the devices and leads, and that Medtronic US was primarily responsible for quality. The Tax Court rejected the IRS’s contentions.

Based on the detailed evidence before it of MPROC’s responsibilities and activities in the production of devices and leads, it found that MPROC did more than assemble components, and its efforts were integral to the success of the CRDM and Neuro business units. With respect to its importance to quality, the court was convinced by MPROC’s extensive activities related directly to quality and quality control, and the economic risks to MPROC of a quality failure, that MPROC did have an important role in quality for devices and leads.

Medtronic’s income allocations: Having held that the IRS’s determination of the allocation of income related to Medtronic’s intercompany sales of devices and leads was incorrect, the court considered whether Medtronic’s allocations were correct. Medtronic, as it had done historically, espoused the CUT method for calculating the allocation of income to MPROC and contended that royalties of 29% of net device intercompany sales and 15% of net leads intercompany sales under the devices and leads licenses were what would have resulted from arm’s-length bargaining. Medtronic supported its allocation amounts with the report and testimony at trial of its expert.

Medtronic contended that its licensing structure with MPROC was comparable to that of a full-fledged entrepreneurial licensee responsible for its own success. Based on his review of a large number of license agreements, Medtronic’s expert concluded that one of Medtronic’s own royalty agreements (the Pacesetter agreement) was the best comparable transaction. The Pacesetter agreement had arisen out of patent infringement litigation between Medtronic and one of its competitors.

To resolve the litigation, the companies agreed to cross-license their pacemaker and implantable cardioverter defibrillator patent portfolios, and the competitor agreed to pay Medtronic royalties of 7% on its retail sale of cardiac stimulation devices. Using this rate as a starting point, the expert made a number of adjustments to reflect the differences between the Pacesetter agreement and the Medtronic US-MPROC agreement and to convert the rate from a retail to a wholesale rate.

The court agreed with the use of the CUT method and found that the Pacesetter agreement was a comparable uncontrolled transaction. However, the court found that Medtronic’s expert had made a raft of errors in adjusting the royalty rate in the Pacesetter agreement to come up with the royalty rates for leads and devices in the Medtronic US-MPROC agreement. Therefore, the court found that the rates claimed by Medtronic were not arm’s-length rates.

The Tax Court’s income allocation: Since it had rejected both parties’ method of allocating the income from the intercompany sales of the devices and leads, the Tax Court then considered how the correct allocation should be calculated. The court found that the CUT method was the correct method to use and that the Pacesetter agreement was a comparable uncontrolled transaction. Like Medtronic’s expert, the court started with the Pacesetter agreement royalty rate, made what it considered to be the correct adjustments due to the differences between the Pacesetter and Medtronic US-MPROC license agreements, and converted the rate from retail to wholesale. Performing these steps, the court determined that the correct royalty rates were 44% for devices and 22% for leads. Although these rates were similar to those in the MOU, the court stated that this was coincidental and that the rates reflected the facts and expert testimony in the case.

Reflections

While determining the “correct” allocation of income from intercompany transactions under the transfer-pricing rules is in most cases a nebulous exercise, the IRS’s income allocation in this case truly lives up to the description “arbitrary, capricious, or unreasonable.” As the court describes in great detail, producing products of extraordinarily high quality is extremely important to success in the implantable medical device industry, and MPROC played a key (if not the primary) role in ensuring the quality of the leads and devices it produced. The IRS was either being obtuse or disingenuous in arguing that the company was nothing more than a run-of-the-mill components manufacturer.

Medtronic, Inc., T.C. Memo. 2016-112