Tax Insights
from Transfer Pricing
Tax Controversy and Dispute Resolution
Medtronic Tax Court decision rejects
IRS’s effort to treat licensee as
routine manufacturer
June 29, 2016
In brief
The U.S. Tax Court on June 9, 2016, in Medtronic, Inc. v. Commissioner, T.C. Memo No. 2016-112
(2016), ruled substantially in favor of medical device manufacturer Medtronic in its transfer pricing
dispute with the IRS, overcoming the IRS’s claim that the U.S.-based parent should have received
substantially higher royalty payments from its related Puerto Rican subsidiary in both 2005 and 2006.
The IRS was seeking adjustments that would have increased Medtronic’s tax obligations by
approximately $1.3 billion.
The court rejected the IRS’s position, which treated the Puerto Rican subsidiary as a contract
manufacturer and shifted essentially all residual income back to the U.S. parent. Instead, the court
adopted the taxpayer’s proposed comparable uncontrolled transaction analysis, but with adjustments
that increased the royalty rate to a rate that had been agreed upon by Medtronic and the IRS in a prior
audit cycle.
The decision represents another loss for the IRS in its attempt, in a number of cases, to support transfer
pricing determinations that attribute only limited returns to subsidiaries operating offshore. The IRS is
currently asserting similar positions in other pending transfer pricing cases. As in prior cases with
similar fact patterns, the court found that the routine manufacturing profit assigned by the IRS was
inadequate given the important functions and risks undertaken by the subsidiary under its license
agreement. As is common in many transfer pricing cases, the court displayed a preference for using a
third-party transactional benchmark, rather than a profits-based analysis, even where the third party
transactional benchmark is imperfect and requires significant adjustments.
In detail
Factual background
Medtronic, Inc. (Medtronic US)
develops, manufactures,
markets, and sells regulated
medical devices. The dispute
dates back to the 2005 and
2006 tax years, before
Medtronic US merged with
Covidien PLC. At stake were
transfer pricing issues involving
Cardiac Rhythm Disease
Management (CRDM) and
Neurological devices and leads
manufactured by Medtronic
US’s foreign subsidiary
operating in Puerto Rico. In
2002, a U.S. company in the
Medtronic group transferred the
company’s Puerto Rican
manufacturing plants and
equipment and workforce to a
new foreign subsidiary,
Medtronic Puerto Rico
Operations Co. (MPROC).
Medtronic US then entered into
a royalty-bearing license with
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MPROC, licensing the right to use the
Medtronic trademark and technology
to manufacture and sell the CRDM
and Neuro devices and leads, which
were Class III medical devices
requiring FDA approval. The license
called for MPROC to pay to Medtronic
US technology royalties of 29% of net
intercompany sales of devices and 15%
of net intercompany sales of leads,
and a trademark royalty of 8% of net
intercompany sales. The license was
later amended to provide for
technology royalty rates of 44% and
26% to reflect an earlier settlement
with the IRS regarding the arm’s
length amount of royalties to be
reported for U.S. income tax purposes.
MPROC purchased components from
Medtronic US’s plants, manufactured
the finished devices and leads in
Puerto Rico, and sold such devices
and leads to Medtronic’s distribution
entity in the U.S. for sale in the U.S.
market. All R&D for the devices and
leads was performed by Medtronic
US.
In total, the dispute involved four
intercompany agreements, including
licensing of manufacturing intangibles
for the production of medical devices
and leads, a trademark license
agreement, a components supply
agreement, and a distribution
agreement.
Positions of the parties
The IRS asserted that Medtronic US
attributed non-arm’s length profits to
MPROC. Medtronic US disagreed and
countered that it had properly
allocated its profits between its Puerto
Rican subsidiary and its U.S.
operations.
At the heart of the dispute was
whether or not MPROC was an
entrepreneurial and autonomous
manufacturer of medical devices, as
asserted by the taxpayer, or as the IRS
maintained, its operations were mere
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assembly plants, playing only a minor
role in a long process of design,
development, and manufacture
carried out by the U.S. parent.
The IRS argued that the reported
royalties of 44% and 26% were too
low, and that Medtronic US should
pay tax on technology royalty income
amounting to 49% of sales in 2005
and 59% of sales in 2006. The IRS
economic analysis backed into the
royalty income by assigning MPROC a
routine manufacturing return (return
on assets) based on a benchmarking of
routine medical device manufacturers
(under an application of the
comparable profits method or CPM),
and allocating all the remaining
profits to Medtronic US. The IRS
economic expert argued that this
result was appropriate because all
economically significant functions,
other than routine assembly, were
performed by Medtronic US. Over
90% of the total system profit was
allocated to Medtronic US under this
approach.
The IRS also argued that MPROC was
earning unreasonably high returns.
The IRS’s economic expert provided
analysis showing that MPROC’s
reported returns were far greater than
those of all companies in the medical
device industry, and four to five times
higher than Medtronic US and its
competitors.
Medtronic US argued that its
originally reported technology
royalties of 44% and 26% were too
high, and that the rates in its original
license agreement (29% and 15%)
were arm’s length. Medtronic US
relied on an analysis of the royalty
rates charged in similar third-party
license agreements, including a
number of agreements between
Medtronic US and third parties.
Court’s analysis
Allocations were arbitrary,
capricious, or unreasonable
The court agreed with Medtronic that
the IRS’s adjustments were arbitrary,
capricious, or unreasonable, since
they did not reflect that MPROC as a
licensee performed functions that
were a critical element contributing to
Medtronic’s overall profitability. The
court found that MPROC was
“[i]nvolved in every aspect of the
manufacturing process” and that its
role in the Medtronic system was
much more important than a routine
assembly function. In particular, the
court found that product quality was a
critical factor in the medical device
industry for the types of life sustaining
devices that MPROC produced, and
that MPROC played a significant part
in developing and implementing
quality standards in its final product
manufacturing.
Further, the court found that MPROC
owned rights to the licensed
intangibles, purchased its own
materials, bore real market risks, and
was not guaranteed a fixed return on
its investments. The court concluded
that the IRS’s proposed method
misleadingly ignored the valuable
intangible assets held by MPROC by
virtue of its license agreement with
Medtronic US.
Observation: The court’s analysis
recognized that license rights may
represent a valuable intangible asset
of the licensee that must be
considered in a transfer pricing
analysis of an intercompany license
arrangement. Although many aspects
of the court’s analysis are fact specific,
the recognition that a licensee’s
license rights, whose value may not be
reported on the balance sheet, may
represent a valuable intangible asset
reflects a principle that may have
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broad application in other cases as
well.
Selection of best method
Because it credited the important role
played by MPROC, the court rejected
the IRS’s proposed CPM, which
benchmarked MPROC’s return based
on the returns realized by routine
manufacturers. Instead, the court
found that a Comparable
Uncontrolled Transaction (CUT)
method similar to that proposed by
Medtronic US was more appropriate.
Although the court in concept
accepted Medtronic US’s CUT
position, it did not adopt this position
wholesale. Rather, it reached its own
conclusion as to the arm’s length
royalty based on its analysis of one
license agreement (presented in
Medtronic US’s expert analysis) that
the court found was most similar to
the license with MPROC. This license
(between Medtronic US and
Pacesetter, later acquired by St. Jude,
in an uncontrolled transaction) was
the result of a patent litigation
settlement, and involved some of the
same technology as that licensed to
MPROC. The Pacesetter license
provided for a 7% royalty rate (of
retail, not wholesale, sales). The court
used this rate as a starting point for its
analysis, making a number of
significant broad adjustments to
account for differences between the
Pacesetter license and the MPROC
license.
 First, to account for the exclusivity
granted to MPROC, Medtronic
US’s expert had increased the
Pacesetter rate to 14%.
 Second, to account for MPROC’s
rights to future technology,
Medtronic US’s expert had
increased the Pacesetter rate by an
additional 3%.
 Third, to account for MPROC’s
continuing ongoing access to
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Medtronic US’s know-how, the
court increased the rate by an
additional 7%.
 Fourth, to account for the high
profits generated by the products
that MPROC manufactured, the
court increased the rate by an
additional 3.5%.
 Fifth, to account for the broader
scope of products covered by the
MPROC agreement, the court
increased the rate by an additional
2.5%.
In total, these adjustments led to a
royalty rate of 30% of retail sales,
which translated into a royalty rate of
44% of wholesale sales (equivalent to
MPROC’s intercompany sales). The
court found that this 44% rate should
apply to the devices, and that a royalty
rate of half that (22%) should apply to
leads, up from Medtronic US’s
proposed 15 %.
The exact amount Medtronic US will
owe has not been determined, as of
the ruling, but will be issued at a later
date, per the court’s decision.
Observation: It may not be mere
coincidence that the final royalty rate
is essentially the same as that agreed
upon between the IRS and the
taxpayer in the earlier audit. The lack
of any specific explanation for the
quantum of the court’s adjustments to
the Pacesetter royalty rate provides
further support for this view.
Nevertheless, the court disclaimed any
intention to emulate the prior
settlement, stating that any
correspondence between the rates
determined by the court and the
previous settlement was “coincidental.
The adjustments were not made to
mimic the [prior settlement] but
rather to reflect the facts and expert
testimony.”
Alternative section 367(d) argument
also rejected
The court also rejected the IRS’s
argument, made in the alternative,
that Medtronic US should recognize
deemed income under section 367(d)
if the IRS royalty position was not
fully sustained. The IRS argued that
the high profits realized by MPROC
must necessarily be attributable to
intangible property that MPROC
received on the original 2002 transfer
of operational assets to MPROC,
which was subject to section 367(d).
Ultimately, the court rejected this
argument because the IRS did not
identify any specific intangible
property that was transferred to
MPROC that should be subject to
section 367(d).
Observation: The court in Medtronic
did not analyze the section 367(d)
issue in depth, but rather summarily
dismissed the IRS argument for
failure to identify a specific property
transfer. In recent years, many
transfer pricing controversies have
featured similar IRS assertions that
outbound intercompany
arrangements or structuring gave rise
to implicit intangible property
transfers to foreign subsidiaries that
were subject to section 367(d). The
IRS continues to press this issue in
several pending court cases. In
addition, to stem what they view as
taxpayer abuse of this provision, the
IRS and Treasury issued proposed
regulations on September 14, 2015,
that would eliminate taxpayers’ ability
to transfer goodwill and going concern
value to foreign subsidiaries tax free
under section 367.
The takeaway
The Medtronic decision represents
another example in which the IRS
failed to convince a court to allocate
only routine manufacturing profits to
an offshore licensee, which the court
found played a more important role in
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the products’ success than reflected in
the IRS’s proposed method. The
decision suggests that the court
prefers to base its determinations
upon direct pricing evidence from
comparable transactions where
available, without too much concern
over the particular profitability results
produced by application of such a
transactional pricing benchmark. In
this respect, the decision resembles
prior Tax Court jurisprudence in cases
with similar fact patterns (for example
Sundstrand Corp. v. Comr., 96 T.C.
226 (1991); Bausch & Lomb, Inc. v.
Comr., 92 T.C. 525 (1989), aff’d, 933
F.2d 1084 (2d Cir. 1991); and Veritas
Software Corp. v. Comr., 133 T.C. 297
(2009), nonacq., AOD 2010-005,
2010-49 I.R.B. (Dec. 6, 2010).
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact:
APMA and Transfer Pricing Controversy
Sean M. O’Connor, Washington DC
+1 202 414 1518
[email protected]
Gregory J. Ossi, Washington DC
+1 202 414 1409
[email protected]
Gregory Barton, Chicago
+1 312 298 6084
[email protected]
Richard H. Lilley, Washington DC
+1 202 414 4329
[email protected]
Transfer Pricing Global and US Leaders
Isabel Verlinden, Brussels
Global Transfer Pricing Leader
+32 2 710 44 22
[email protected]
Horacio Peña, New York
US Transfer Pricing Leader
+1 646 471 1957
[email protected]
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