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Medtronic, Inc. v. Commissioner of Internal Revenue

United States Court of Appeals, Eighth Circuit

August 16, 2018

Medtronic, Inc. & Consolidated Subsidiaries Appellee
v.
Commissioner of Internal Revenue Appellant

          Submitted: March 14, 2018

          Appeal from The United States Tax Court

          Before WOLLMAN, SHEPHERD, and ERICKSON, Circuit Judges.

          WOLLMAN, CIRCUIT JUDGE.

         The Commissioner of Internal Revenue (Commissioner) appeals from the tax court's valuation of Medtronic, Inc. and its consolidated subsidiaries' (Medtronic) true income for the 2005 and 2006 tax years.

         The Commissioner characterizes this dispute as involving "the classic case of a U.S. multinational taxpayer (Medtronic) shifting income from its highly profitable U.S. operations and intangibles to an offshore subsidiary operating in a tax haven (Medtronic [Puerto Rico]), by charging an artificially low rate for the intangibles." Appellant's Reply Br. 1. Medtronic's view of the case is that because its Puerto Rico subsidiary bears the lion's share of potential liability arising from any defectively manufactured products, it was entitled to a commensurate rate of return on its operations there. Appellee's Br. 21-26.

         The Commissioner argues that the tax court erred in not applying the correct transfer pricing method when calculating the arm's length royalty rates for Medtronic's intercompany licenses. We vacate the tax court's order and remand for further proceedings consistent with this opinion.

         I. Background

         Medtronic is a medical device company that produces and markets class III devices, which include implantable cardiac pulse generators and neurological stimulators (devices), as well as other medical therapy devices (leads). Medtronic's parent company, Medtronic US, and its distributer, Medtronic USA, Inc. (Med USA), are located in the United States, and its class III device manufacturer, Medtronic Puerto Rico Operations Co. (Medtronic Puerto Rico), is located in Puerto Rico. Medtronic allocates the profit earned from its devices and leads between Medtronic US, Med USA, and Medtronic Puerto Rico through its intercompany licensing agreements.

         Medtronic's 2002 consolidated tax return used the comparable uncontrolled transactions (CUT) transfer pricing method to determine the royalty rates paid on its intercompany licences. The Internal Revenue Service's (IRS) audit of the return left it with the concern that Medtronic was shifting too much profit from its devices and leads to Puerto Rico in an attempt to avoid taxation in the United States. Using the residual profit split transfer pricing method, the IRS concluded that 90% of Medtronic's devices and leads profit should be allocated to the United States operations and 10% to the Medtronic Puerto Rico operations. To resolve the audit, Medtronic and the IRS entered into a Memorandum of Understanding (Memorandum) in which Medtronic Puerto Rico agreed to pay royalty rates of 44% for devices and 26% for leads on its intercompany sales. The IRS in return agreed to apply the Memorandum's royalty rates in future years "as long as there [were] no significant changes in any underlying facts." Neither party considered the Memorandum's royalty rates to be an arm's length price, but rather as only a compromise in an effort to resolve the audit.

         The IRS and Medtronic could not agree on how the Memorandum should apply to Medtronic's royalty income for the 2005 and 2006 tax years. After completing an initial audit of Medtronic's transfer pricing method, the IRS determined that the comparable profits method-not the CUT method-was the best way to determine an arm's length price for Medtronic's intercompany licensing agreements for those two years.[1] Using the comparable profits method to determine the royalty rates for intangibles under the intercompany licensing agreements, the IRS concluded that the rate paid by Medtronic Puerto Rico was too low, resulting in tax deficiencies for 2005 and 2006. Accordingly, the Commissioner proposed an initial adjustment of $84 million based on his revised calculations under the Memorandum. Medtronic contested the IRS's determinations, arguing that the CUT method should instead be used to calculate an arm's length price. Medtronic further claimed an overpayment of its taxes based on its original royalty rates under the intercompany licenses.

         After completing the audit, the Commissioner proposed to increase the royalty payments paid by Medtronic Puerto Rico to Medtronic U.S. by an additional $455 million. Following Medtronic's appeal to the IRS's Appeals Office, the Commissioner requested that the case be returned to the IRS for reexamination. Thereafter, the Commissioner again used the comparable profits method to calculate the arm's length royalty rates, following which he issued Medtronic a notice of deficiency totaling $198, 232, 199 for 2005 and $759, 383, 578 for 2006. Approximately seven months later, the Commissioner amended the notice, asserting that the initial adjustments were understated and that Medtronic's deficiencies as related to devices and leads were actually $548, 180, 115 and $810, 301, 695 for 2005 and 2006, respectively.

         Medtronic filed suit in United States Tax Court, arguing that the CUT method, not the comparable profits method, was the best method for determining an arm's length price for the intercompany licenses.[2] After a nearly six-week trial, the tax court rejected both parties' royalty rate valuations. In doing so, the tax court held that the Commissioner's "allocations were arbitrary, capricious, or unreasonable." The court also found that the comparable profits method "downplayed" Medtronic Puerto Rico's role in ensuring the quality of the devices and leads, that it did not reasonably attribute a royalty rate to Medtronic's profits, that it used an incorrect return on assets approach, that it improperly aggregated the transactions, and that it ignored the value of licensed intangibles. Similarly, the tax court concluded that Medtronic's CUT method did not produce an accurate arm's length adjustment because it did not distinguish between devices and leads and therefore produced a result that was unconvincing and overly broad.

         The tax court then engaged in its own valuation analysis. It ultimately decided that Medtronic's CUT method was the best way to determine an arm's length royalty rate for intercompany agreements, but made a number of adjustments. In doing so, it found that the arm's length royalty rate for the device licenses was 44% and the rate for the lead licenses was 22%. It thereafter issued an order concluding that Medtronic had an income tax deficiency of $26, 711, 582.00 in 2005, but that it had an income tax overpayment of $12, 459, 734.00 in 2006. The Commissioner then filed ...


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