The prolonged tax battle between medical device manufacturer, Medtronic Inc., and the Commissioner, underscores the complexities involved in choosing the most appropriate transfer pricing method, particularly when it comes to transfers involving intangible property. This dispute pertains to the pricing of licenses between the U.S.-based parent company, Medtronic, and its subsidiary, Medtronic Puerto Rico Operations Co (MPROC).
The case, in litigation since 2016, has returned to the U.S. Court of Appeals for the Eighth Circuit, with the IRS arguing that the Tax Court’s 2022 ruling violates Section 482 of the tax code for pricing intangibles. According to Section 482 regulations, the Tax Court is required to select the “best method” for pricing Medtronic’s intangibles. The IRS contends that the court should have recognized its suggestion – the comparable profits method – as more reliable than Medtronic’s proposal, which isn’t specified in the Treasury regulations.
The sequence of decisions from the Tax Court and Eighth Circuit cast doubts on the usefulness of Medtronic’s preferred method, the comparable uncontrolled transaction (CUT) method, in transfer pricing. Complications arise in finding reliable CUTs to benchmark unique and high-value intangible assets and intricate value chains. As per regulations, companies have to make comparability adjustments to a CUT, reflecting changes in profit potential, risk, and functions between controlled and uncontrolled transactions. However, these cumulative adjustments risk modifying a transaction to the point where it no longer resembles the original.
Due to the complexity of these adjustments and contentious outcomes, both the Medtronic and the Tax Court made significant amendments to a 1992 agreement with Siemens Pacesetter in 2022. There is ambiguity surrounding whether this agreement serves as a valid basis for applying the CUT method. Given these issues with the CUT method, the solution for taxpayers, especially in light of IRS’s appeal, remains elusive.
The Tax Court in 2016 criticized the IRS’s application of the comparable profits method for undervaluing MPROC’s quality control function and cited several other flaws. This debate on the application of the comparable profits method is also central to Amgen’s appeal in relation to its manufacturing in Puerto Rico.
That said, such critiques don’t negate the potential for a more robust application of the comparable profits method, which doesn’t demand the strict comparability criteria of the CUT method. The broader question then, in cases like Medtronic’s, is whether the IRS can identify comparable companies that are closer in key value drivers to MPROC.
Towards the end, the Tax Court resorted to an unspecified method, a practice seen infrequently that tends to invite scrutiny from tax authorities. Rather than providing a clear roadmap, the Tax Court combined the CUT method, the comparable profits method, and an unexplained residual profit split, which may appear arbitrary to many.
While the long-running court battle reveals the stark differences in methods chosen by Medtronic and the IRS, most taxpayers would prefer to avoid such a conflict. Perhaps a sensible approach would be for taxpayers to prepare transfer pricing studies that present the best method while offering alternative methods as corroboration. A demonstration that a taxpayer’s results can be replicated by using several methods, reliably adjusted, could support the arm’s-length nature of transactions.
The case is Medtronic, Inc. v. Commissioner, with a brief filed on Feb. 16, 2024.