US Inbound: Medtronic wins US transfer pricing case
Medtronic is a recent and important US transfer pricing case. The case involved, among other things, the royalty rate payable by a Puerto Rican affiliate of the US taxpayer that produced medical device products.
In a cycle prior to the years at issue in the case, the taxpayer and the IRS agreed in a Memorandum of Understanding (MoU) to adopt the taxpayer's use of the comparable uncontrolled transaction (CUT) method, with certain adjustments.
In the years at issue in the case, the IRS abandoned the methodology used in the MoU and proposed substantial adjustments based on a comparable profits method (CPM) analysis. The taxpayer, in turn, argued for a refund, asserting that the royalty rate should be based on the comparable transaction that formed the basis of the prior settlement, but without the adjustments agreed to in the MoU.
The Puerto Rican company contributed to the design process, had a role in product development, and bore market risks. The court found the Puerto Rican company was an integral part of the taxpayer's operations. The court criticized the IRS economist's approach for, among other things, ignoring valuable intangible assets held by the Puerto Rican company, but that were not recorded on its balance sheet.
Medtronic contended that the transactions in issue, which also included supply and distribution transactions, should not be aggregated and that aggregation would treat the Puerto Rican company more like a contract manufacturer, failing to take into account its full role. The IRS contended that aggregating transactions was required.
The court held that the functions at issue can exist independently and that the transfer pricing regulations do not require that the transactions be aggregated. Transactions may be aggregated under the regulations if an aggregated approach produces the "most reliable means of determining the arm's length consideration for the controlled transactions." Here, the covered transactions were accounted for and priced separately in the marketplace. According to the reasoning of the case, aggregation did not result in a reasonable determination of true taxable income.
Additionally, the court stated that the commensurate with income standard under § 482 does not replace the arm's-length standard. It cited Altera Corp. v. Commissioner, 145 T.C. (2016), and Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010). Thus, the court held that the IRS's use of CPM is not required under the § 482 commensurate with income standard and the IRS's arguments regarding that standard did not change the court's view that the IRS's allocations were unreasonable.
Medtronic still had to prove that its royalties met the arm's length standard. It relied on its comparable arm's length license without further adjustment. The court found that the comparable transaction, standing alone, was not arm's length because appropriate adjustments had not been made to account for variations in profit potential.
The court did agree, however, with Medtronic that the comparable transaction could serve as a starting point. In addition, it said the CUT method was the best choice because the comparable involved some of the same intangibles, which were licensed under comparable circumstances. However, the court made adjustments to the royalty rate.
The end result, according to the court, was close to the parties' settlement of the prior cycle as reflected in their MoU.
Fenwick & West