The Tax Court issued its second opinion in Medtronic following a remand by the US Court of Appeals for the Eighth Circuit (Medtronic, Inc. v. Comm’r, 900 F.3d 610 (8th Cir. 2018)) of its earlier decision. In that earlier opinion (Medtronic I), the Tax Court held that Medtronic appropriately applied a comparable uncontrolled transaction (CUT) method to determine the arm’s-length royalty rate for certain licensing of intangible property, using a 1992 patent litigation settlement agreement with Siemens Pacesetter, Inc. (Pacesetter Agreement) as its CUT. The Eighth Circuit was not convinced and asked the Tax Court to reconsider whether the CUT method was the best method for determining the arm’s length royalty between Medtronic and its Puerto Rican subsidiary and what the proper royalty rate should be.

The IRS maintained it position that the Pacesetter Agreement was not a CUT because the patent licenses were not comparable and the Pacesetter Agreement was not entered into in the ordinary course of business. Furthermore, the IRS contended that using the Pacesetter Agreement as a CUT resulted in MPROC’s receiving the “lion’s share” of profits earned from the sales of Cardiac Rhythm Disease Management (CRDM) and Neurological (Neuro) products, dwarfing that of Medtronic US, the owner of the “crown-jewel” intangibles.

On remand, the Tax Court reexamined the methods proposed by both parties and concluded that neither the CUT method nor the comparable profits method (CPM), which was urged by the IRS, was best. The CUT in Medtronic I required too many adjustments, and the IRS’s CPM is an abuse of discretion since it results in an unrealistic profit split and too high a royalty rate. So the Tax Court decided that a third, unspecified method—between the two—should apply. Although Medtronic’s CUT was not upheld, the third method resulted in a rate that was much closer to Medtronic’s original position than the one urged by the IRS.

We noted in our prior legal alert that this case highlighted the dual burden faced by a taxpayer in a transfer pricing case, where a taxpayer must first convince a court to reject the IRS’s transfer pricing method as an abuse of discretion, and then show that the taxpayer’s method led to a proper arm’s-length result. We also noted that this case highlighted the significant discretion a court may have in devising its own transfer pricing method, which is what can happen if the court finds that the taxpayer has met the first part of its dual burden but not the second. The thorough and detailed decision of the Tax Court exemplifies this discretion and provides welcome insight into this area of law.

The CUT, the CPM, and the Unspecified Method

Throughout each phase of this case, Medtronic asserted that the Pacesetter Agreement could be reliably used to establish the royalty rate for the intangibles licensed to MPROC and also asserted that the Pacesetter Agreement with appropriate adjustments remained a CUT. In its post-trial briefs and at a post-trial hearing, Medtronic proposed an alternative, unspecified method. The IRSs position is that the CPM was the best method and that the Pacesetter Agreement was not a CUT under the regulatory standards. The IRS rejected Medtronic’s proposed unspecified method and argued that it was based upon the same flawed methodology used in Medtronic’s CUT method. The IRS further argued that Medtronic proposed to correct deficiencies in its CUT by making adjustments to the Pacesetter Agreement, which produced “the deficiencies in the first place,” referring to IRS’s arguments in Medtronic I that the Pacesetter Agreement was not comparable to the MPROC licenses.

Back to the Beginning

In Medtronic I, the Tax Court held that the CUT method (adjustments made to the Pacesetter Agreement) was the best method for determining the arm’s-length rate and concluded that a reasonable wholesale royalty rate for the medical devices is 44%, a reasonable wholesale royalty rate for the leads is 22%, and the wholesale royalty rate for devices should be 44% for the Swiss supply agreement. The court concluded that the blended wholesale royalty rate was 38%.

The Eighth Circuit disagreed, vacating and remanding the Tax Court’s decision and ordering the Tax Court to make several additional findings to justify more extensively the transfer pricing method that Medtronic could use. The court explained that the Tax Court’s findings were insufficient to support using the Pacesetter Agreement as a comparable transaction. So the court asked the Tax Court to provide: (1) sufficient detail as to whether the circumstances between Siemens Pacesetter, Inc., and Medtronic US were comparable to the licensing agreement between Medtronic US and Medtronic Puerto Rico (MPROC) and whether the Pacesetter Agreement was one created in the ordinary course of business; (2) an analysis of the degree of comparability of the Pacesetter Agreement’s contractual terms and those of the MPROC’s licensing agreement; (3) an evaluation of how the different treatment of intangibles affected the comparability of the Pacesetter Agreement and the MPROC licensing agreement; and (4) the amount of risk and product liability expense that should be allocated between Medtronic US and MPROC. The Eighth Circuit deemed such findings essential to its review of the Tax Court’s determination that the Pacesetter Agreement was a CUT and necessary to its determination of whether the Tax Court applied the best transfer pricing method for calculating an arm’s length result or whether it made proper adjustments under its chosen method.

The Tax Court on remand issued an order on May 3, 2019, scheduling further trial for additional expert testimony. The court expected the parties’ experts to address a number of distinct points which, together, supported the mandate given by the Eighth Circuit to consider: whether the CUT method is the best method for determining the arm’s-length rate; what the proper royalty rates are for the devices and the leads; and what the proper royalty rate is for devices sold pursuant to the Swiss supply agreement. The points addressed by the experts and decided by the court are as follows:

1.     Whether the Pacesetter agreement is a CUT

The Tax Court determined that the Pacesetter Agreement was not identical to the MPROC licenses and in light of the general comparability factors, the Pacesetter Agreement and the MPROC licenses were not similar enough to meet the comparability requirements of the regulations. Thus, the Pacesetter Agreement was not a CUT.

2.     Whether the Tax Court made appropriate adjustments to the Pacesetter agreement as a CUT

The Tax Court reviewed its adjustments in Medtronic I and concluded that adjustments can be made to the Pacesetter Agreement, but that that too many adjustments to the Pacesetter Agreement as a CUT resulted in the CUT method not being the best method pursuant to the section 482 regulations.

3.     Whether the circumstances between Pacesetter and Medtronic US were comparable to the licensing agreement between Medtronic and MPROC and whether the Pacesetter agreement was an agreement created in the ordinary course of business

The Tax Court found that the Pacesetter Agreement occurred in the context of resolving litigation by clarifying Pacesetter’s and Medtronic US’s rights and obligations over the Medtronic US patents; the court concluded that the Pacesetter Agreement was reached in the ordinary course of business. And the Tax Court noted that this conclusion was not enough to conclude that the Pacesetter Agreement was a CUT for the purpose section 482.

4.     An analysis of the degree of comparability of the Pacesetter agreement’s contractual terms and those of the MPROC licensing agreement

The Tax Court noted that even though there is a level of comparability between the Pacesetter Agreement and the MPROC licenses, it is not enough to conclude that the CUT is the best method. However, even though the Tax Court found that there were enough differences between the Pacesetter Agreement and MPROC licenses to conclude that the Pacesetter Agreement was not a CUT, there were enough similarities that the Pacesetter Agreement could be used as a starting point for determining a proper royalty rate.

5.     An evaluation of how the different intangibles affected the comparability of the Pacesetter agreement and the MPROC licensing agreement

The Tax Court found that the intangibles at issue were not comparable enough to meet the general comparability factors.

6.     An analysis that contrasts and compares the CUT method using the Pacesetter agreement with or without adjustments and the comparable profits method (CPM), including which method is the best method

The Tax Court concluded that the CUT in Medtronic I required too many adjustments and that the IRS’s CPM was an abuse of discretion since it resulted in an unrealistic profit split and too high a royalty rate. Hence, in the court’s view neither method was the best method. As explained in incredible detail in the Tax Court’s decision, and as summarized below, the Tax Court worked through the morass of expert opinions and adopted an unspecified method that existed between the parties’ respective positions.

The Best Method

In determining the best method, the Tax Court noted that the regulations provide that when determining which method provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are (1) the degree of comparability between the controlled transaction (taxpayer) and any uncontrolled comparables and (2) the quality of the data and assumptions used in the analysis. Treas. Reg. § 1.482-1(c)(2). The Tax Court examined the IRS’s CPM method reducing the number of comparables and making an adjustment for product liability that resulted in wholesale royalty rates of 59.6% for 2005 and 64% for 2006 (modified CPM). The modified CPM resulted in retail royalty rates of 40.7% and 48.8% for 2005 and 2006, respectively, and wholesale royalty rates of 59.6% and 64% for 2005 and 2006, respectively, whereas the CPM without modifications resulted in wholesale royalty rates of 64.3% and 68.4% for 2005 and 2006, respectively. The modified CPM resulted in MPROC’s earning 14% of the profits in 2005 and 12% of the profits in 2006. The CPM without modifications resulted in MPROC’s earning 8.1% of the profits in 2005 and 5.6% of the profits in 2006. The Tax Court found that the IRS’s modified CPM was a minor change to the CPM and that the modifications were not enough to overcome the flaws. Therefore, the modified CPM was not the best method and there was an abuse of discretion by the IRS due to the use of flawed comparables.

Medtronic maintained its position that the CUT was the best method and that the Pacesetter Agreement was a valid CUT. In response to the Tax Court’s questions and comments at the conclusion of the further trial and the post-trial hearing, Medtronic changed its focus to its proposed unspecified method. In its post-trial answering brief, Medtronic contended that its unspecified method “bridges the gap” because it addressed the court’s questions about the profitability of its CRDM and Neuro businesses relative to Pacesetter. Medtronic recommended two versions of an unspecified method that combined aspects of the CUT (with the Pacesetter Agreement as a comparable) and of the CPM. Medtronic rejected an unspecified method averaging the CUT and the CPM and further rejected considering alternatives because it contended that there was “no gap to bridge” beyond its unspecified method.

The CUT method and the CPM both provide information that is helpful in determining whether a method is the best method. The CUT method focuses on price, whereas the CPM focuses on profit benchmark. The IRS argued that that there was not a sufficient level of comparability with the Pacesetter Agreement so the CUT method was problematic; Medtronic contended that the IRS’s CPM used companies that differed fundamentally from MPROC. If neither party proposes a method that constitutes “the best method,” the court is tasked with determining the proper allocation of income based on the record. The Tax Court noted that there were some benefits to the CUT and that the Pacesetter Agreement was an appropriate comparable as a starting point. The court reviewed the adjustments made in Medtronic I and concluded that improvements could be made to the adjustments since the CUT method was not the best method. However, the court aptly noted that since there is only one comparable, adjustments would need to be made, and if too many adjustments were made, the Pacesetter Agreement might cease to be useful even as a starting point.

As the Tax Court noted, it is not unique for the court to be required to determine the proper transfer pricing method in transfer pricing cases. None of Medtronic’s CUT method, Medtronic’s proposed unspecified method, the court’s adjusted CUT method in Medtronic I, the IRS’s CPM, or the IRS’s modified CPM resulted in an arm’s-length royalty rate; none were the best method. Hence, the court was tasked in finding a solution that was not simply a hybrid of the CUT method and the CPM, but rather one that undertook a detailed analysis in the context of the Eighth Circuit’s mandate and that considered the level of technology needed to make safely the devices and leads. Even though the Tax Court rejected Medtronic’s unspecified method, the court relied on Medtronic’s methodology as setting forth a framework for the court’s determination of the appropriate royalty rate for devices and leads. The court noted that adjustments needed to be made to account for the inadequacy of Medtronic’s CUT method – (1) only one comparable, (2) too many adjustments, and (3) inadequate adjustments for profit potential. The court noted that the Pacesetter Agreement was not ideal, but it was an appropriate starting point.

Medtronic proposed an unspecified method that combined elements of the CUT and the CPM and provided two versions of this method, each consisting of three steps:

• The first step applies a modified version of Medtronic’s CUT method and the arm’s-length wholesale royalty rate of 8% for the trademark license to allocate profits to Medtronic US’s R&D activities.
• The second step applies a modified version of the IRS’s CPM to allocate profit to MPROC’s activities. After completing the first two steps and allocating a portion of profit for tax years 2005 and 2006, a portion of device and lead system profit remains unallocated.
• The third step allocates the remaining profit between Medtronic US and MPROC. This step differs from the CUT method and the CPM and is a way to adjust the royalty rates without having to make further adjustments to the CUT.

The Tax Court determined that Medtronic’s unspecified method could be used to address prices and profits such that no adjustments needed to be made to the first two steps. The third step required an adjustment whereby allocating more of the remaining profits in step three to Medtronic US, a higher royalty rate could be achieved. The adjustment to the third step increased the allocation of remaining profits to Medtronic US, resulting in an allocation of 80% to Medtronic US and 20% to MPROC (80–20 allocation). This adjustment was a way of accounting for the imperfections of the CUT method, such as “know-how,” having only one comparable, differences in profit potential, and imperfections of the CPM like the inadequacy of the comparables and an unrealistic profit allocation to MPROC. Changing the allocation to 80–20 resulted in a wholesale royalty rate of 48.8% for both leads and devices, and the royalty rate is the same for both years in issue. The royalty rate of 48.8% resulted in an overall profit split of 68.72% to Medtronic US/Med USA and 31.28% profit split to MPROC and a R&D profits split of 62.34% to Medtronic US and 37.66% to MPROC. The resulting profit split reflected the importance of the patents as well as the role played by MPROC. The court found that a wholesale royalty rate of 48.8% for both devices significantly bridged the gap between the parties – Medtronic’s proposed CUT which resulted in a blended wholesale royalty rate of 21.8% and the IRS’s CPM analysis which resulted in a blended wholesale royalty rate of 67.7%. Similarly, the Tax Court determined that the wholesale royalty rate for devices covered by the Swiss Supply Agreement was 48.8% since the court concluded in Medtronic I that the issue should be resolved in the same manner as the section 482 issue regarding devices.

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