by Julie Martin
A US federal appeals court on August 16 vacated and remanded the Tax Court’s 2016 decision in Medtronic v. Commissioner, handing a win to the IRS in the latest round of this billion-dollar, long-running transfer pricing dispute over royalty rates.
The United States Court of Appeals for the Eighth Circuit has ruled that the Tax Court did not adequately justify its conclusion that the comparable uncontrolled transaction (CUT) method was the best transfer pricing method for determining arm’s length royalty rates for intangibles under an intercompany license agreement and said that it lacked sufficient information to review the appropriateness of the Tax Court’s reliance on a particular CUT.
Transfer pricing royalty rates
The dispute concerns the value of an intercompany license of intangible property agreed to by Medtronic and its Puerto Rican manufacturing subsidiary for the subsidiary’s use of intangible property required to manufacture medical devices and leads.
The IRS increased Medtronic’s 2005 and 2006 tax bill by a total of $1.4 billion, in part because it determined that Medtronic should have used the comparable profits method to calculate arm’s length royalty rates under the agreement rather than the CUT method applied by the taxpayer.
Medtronic challenged the IRS assessments in Tax Court, which, in a June 2016 opinion, concluded that Medtronic met its burden of proving that IRS’s Section 482 allocations were arbitrary, capricious, or unreasonable. The Tax Court found several flaws in the transfer pricing method selected by the IRS, including the fact that it did not put enough weight on the Puerto Rico sub’s role of ensuring that the products it manufactured were of good quality.
The Tax Court went on to also reject Medtronic’s valuation and applied a CUT method with some adjustments. The Tax Court used as a CUT a 1992 license agreement that was a part of a litigation settlement between Medtronic and another company that included cross-licenses and a lump sum payment. This finding and the court’s conclusions on three other intercompany agreements and other items led the Tax Court to conclude that Medtronic had a tax deficiency in 2005 of $26.7 million and an overpayment in 2006 of $12.4 million.
Eight Circuit decision
The IRS then appealed the Tax Court’s decision to the Eighth Circuit, challenging the court’s conclusions concerning the medical devices and leads royalty rates. The Eighth Circuit has now sided with the IRS, vacating and remanding the Tax Court decision.
The Tax Court did not provide information, the Eighth Circuit said, on whether the circumstances of the agreement associated with the 1992 settlement were comparable to the intercompany arrangement at issue. Treasury regulations state that transactions not in the ordinary course of business, such as litigation settlements, are generally not considered reliable for arm’s length purposes, the court noted.
The Tax Court decision also does not discuss the degree of comparability of contractual terms nor does it evaluate the implications of the fact that different intangibles were addressed in the two agreements, the Eighth Circuit said.
Finally, the Eighth Circuit noted that the Tax Court did not make specific findings regarding the risk and product liability expense to be allocated between the two companies even though Tax Court rejected the IRS’s comparable profit method on the grounds that the comparable companies the IRS selected did not bear risk similar to the risk incurred by the Puerto Rico sub. The appellate court said that it needed such findings to conduct its review of the transfer pricing royalty rates.
As such, the Tax Court failed to provide facts showing that 1992 license agreement was an appropriate CUT and that the CUT method was the best method to determine transfer pricing royalty rates in this instance, the Eighth Circuit concluded.
In his concurring opinion, Judge Bobby E. Shepherd said that an analysis of the factors listed by the majority was not only needed to conduct an appellate review but was also mandated by Treasury guidelines. Judge Shepherd also said that he doubted the 1992 agreement could serve as a CUT in the instant case.
Julie Martin
Julie Martin is the founder of MNE Tax. She edits the publication and regularly contributes articles on new developments in cross-border business taxation.
Julie has worked as a tax journalist and editor for more than 13 years. Prior to that, she worked as an in-house tax attorney in New York. She also holds an LLM in taxation from New York University School of Law.
Julie can be reached at [email protected].
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