Taxpayers celebrate Medtronic's victory in US Tax Court
In a significant victory for the taxpayer, the US Tax Court in Medtronic, Inc. v. Commissioner, T.C. Memo 2016-112, held that the Internal Revenue Service's (IRS's) transfer pricing adjustments (which amounted to almost $1.4 billion for the 2005 and 2006 tax years) were arbitrary, capricious, or unreasonable. The Tax Court's decision in Medtronic follows significant taxpayer victories in other § 482 cases, including Veritas v. Commissioner, 133 T.C. 297 (2009), nonacq, and Altera Corporation v. Commissioner, 145 T.C. 91 (2015).
The primary issue in Medtronic was whether income related to certain intercompany licenses for intangible property required to manufacture medical devices and leads should be reallocated under § 482 from Medtronic US to its Puerto Rican subsidiary (MPROC). Interestingly, the taxpayer and the IRS had reached an agreement on the royalty rates in a prior audit cycle, which resulted in a memorandum of understanding (MoU) between the parties regarding the royalties. However, after completing its examination of Medtronic's 2005 and 2006 tax returns, the IRS departed from the approach in the MoU and asserted a large royalty adjustment, which prompted Medtronic to then assert a refund based on its pre-MoU pricing.
While the taxpayer in Medtronic applied the comparable uncontrolled transaction (CUT) method to determine the arm's-length royalty rate on the intercompany sales, the IRS asserted that the comparable profits method (CPM) was the best method to determine the arm's-length royalty rates on intercompany sales. The IRS's position was based largely on its contention that MPROC performed only assembly of finished products, with Medtronic US performing all other economically significant functions.
The Tax Court rejected the IRS's use of the CPM method, as well as the IRS's characterisation of MPROC as providing only minimal contributions and functions. The court stated that the commensurate-with-income standard under § 482 does not replace the arm's-length standard, and that the IRS's use of CPM was therefore not required under the commensurate-with-income standard.
The court ultimately found that the royalty rates charged for the intercompany sales of devices and leads were not at arm's-length because certain adjustments were required to account for variations in profit potential. However, the Tax Court also appeared to criticise the IRS for adopting an all-or-nothing approach by advocating a result based on the CPM using a value chain methodology, while refusing to suggest adjustments to Medtronic's CUT method for the devices and leads. Ultimately, the royalty rates determined by the court appeared to generally fall in line with the royalty rates previously agreed to in the MoU.
Significantly, the Tax Court rejected the IRS's proposed aggregation of the transactions at issue, which would have treated MPROC as an ordinary contract manufacturer. Noting that the functions at issue in the covered transactions are able to exist independently, the court determined that aggregation was not the most reliable means of determining arm's-length consideration for the controlled transactions.
The Tax Court also rejected the IRS's alternative argument that if a § 482 adjustment was not warranted, then Medtronic should be required to recognise a deemed royalty under § 367(d) for the transfer of intangible property by Medtronic US to MPROC. The Tax Court rejected this IRS's alternative argument, stating that the IRS did not identify specific intangibles that were purportedly transferred from Medtronic US to MPROC.
Cost-sharing arrangements in Altera are still in contention
The IRS has filed its appeal of the Tax Court's decision in Altera Corporation v. Commissioner, 145 T.C. 91 (2015), in the Ninth Circuit. Altera is a follow-on to Xilinx v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010).
In Xilinx, the Tax Court held that unrelated parties would not agree to share the costs of stock-based compensation in a cost-sharing arrangement. The Ninth Circuit, in affirming the lower court decision, held that the "all costs" requirement of the 1995 cost-sharing regulations were irreconcilable with the arm's-length standard. In an effort to overrule a negative decision in Xilinx, the Treasury and the IRS in 2003 issued a specific stock-based compensation rule under Treas. Reg. § 1.482-7(d)(2). The 2003 regulation requires controlled parties entering into cost-sharing agreements to share stock-based compensation costs.
The Tax Court in Altera held that the 2003 regulation was invalid because it failed to satisfy the reasoned decision-making standard under Motor Vehicle Manufacturers Association of the US Inc. v. State Farm Mutual Auto Insurance Co., 463 US 29 (1983). The court also stated that the Treasury violated the Administrative Procedures Act when it failed to consider commentary that unrelated parties never share the cost of stock-based compensation. The Tax Court also held that under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 US 837 (1984), "the final rule is invalid because it is 'arbitrary or capricious in substance' [citations omitted], and therefore cannot be justified as being a reasonable interpretation of what sec. 482 requires". The Treasury is not permitted to arbitrarily define what is arm's-length. The Tax Court stated that the "Treasury's ipse dixit conclusion, coupled with its failure to respond to contrary arguments resting on solid data, epitomises arbitrary and capricious decision-making".
Altera is an important case for taxpayers. The case is a taxpayer victory on not only the narrow stock-based compensation issue, but it also establishes an important precedent for challenging regulations that are issued by the IRS without reasoned decision making.
The Department of Justice (DoJ) filed its appellate brief with the Ninth Circuit on June 27 2016. The DoJ's brief largely makes the same arguments the government made, and lost on, in Xilinx. Two different amici briefs have been filed by law professors arguing that the Ninth Circuit should uphold the 2003 regulation as a reasonable exercise of the Treasury's statutory authority.
IRS challenges Coca-Cola's royalty payments
In another large transfer pricing case, the IRS has proposed a $9.4 billion income adjustment ($3.3 billion tax deficiency) related to intercompany royalties that were charged by Coca-Cola to seven foreign affiliates.
The IRS's royalty adjustment pertains to trademark and product formula licenses that were granted to the foreign affiliates who used these licensed rights to produce beverage concentrates. The foreign affiliates sold the beverage concentrates to third-party bottlers, who in turn produced and sold the finished beverage products to distributors and retailers. Although the IRS's asserted adjustments are significant, the potential long-term continuing impact on Coca-Cola is likely to be much larger if the continuing intercompany royalty rates are adjusted.
Interestingly, the IRS's position in this case bears some similarities with the IRS's position in Medtronic, discussed above.
First, the taxpayer and IRS apparently had reached a formal agreement regarding the intercompany royalties in an earlier year, which had been consistently applied for a number of years. The IRS's proposed royalty adjustment appears to be a significant departure from the methodology that was previously agreed to, and consistently applied.
Second, as it did in Medtronic, the IRS is attempting to apply the comparable profits method in a manner that would suggest that the foreign licensee is entitled only to routine returns, with all non-routine profits being assigned to the US parent.
The taxpayer's petition accuses the IRS of adopting an inconsistent position in a separate adjustment. In a situation where Coca-Cola's Canadian subsidiary owned the IP, the IRS allocated only a routine return to the legal owner of intangible property and allocated all residual profits to the US parent who purportedly bore the entrepreneurial risk. The petition also notes that the IRS's $9.4 billion income adjustment would total more than 100% of the aggregate operating profits of the foreign licensees.
Given that this case is still in the early stages, with the taxpayer having filed its petition in the Tax Court in December 2015 and the IRS having filed its answer in February 2016, it will be a while before we can expect the court to reach a decision (assuming that the case is not settled beforehand, which seems unlikely likely given that the IRS designated this case for litigation).
The IRS has appealed the Santander case concerning anti-abuse doctrines
In Santander Holdings USA v. US, the Massachusetts District Court granted a summary judgment for the taxpayer, stating that the judicial anti-abuse doctrines of economic substance and substance-over-form do not invalidate a STARS foreign tax credit generator.
The judge criticised the earlier decisions in Salem Fin., Inc. v. United States, 786 F.3d 932, 937-39 (Fed. Cir. 2015), petition for certificate filed (US September 29 2015) (No. 15-380), and Bank of N.Y. Mellon Corp. v. Commissioner, 801 F.3d 104, 110-12 (2d Cir. 2015), petitions for certificate filed (US October 13 2015) (No. 15-478) and (US November 2 2015) (No. 15-572), stating that what the government is really doing is defending double taxation. In a very articulate and well-reasoned opinion, the judge criticised the IRS for making moral judgments rather than using legal rationality and stated that the anti-abuse doctrines should be analytical and not visceral.
The government has appealed the Santander District Court decision with the First Circuit (brief filed on June 9 2016), arguing that Santander did not generate a profit on a pre-tax basis. The case is ongoing.
IRS to stop using outside law firms in audits after Microsoft dispute
Microsoft's transfer pricing methodology for its cost-sharing arrangements are in dispute, which could lead to a multi-billion dollar income adjustment. This could be the largest transfer pricing issue to date. IRS officials have stated that this is one of the largest audits in IRS history.
The Microsoft dispute made headlines when Microsoft challenged the IRS's use of outside law firm Quinn Emanuel Urquhart & Sullivan. Quinn is primary outside counsel to Google, one of Microsoft's largest competitors. The IRS filed a summons enforcement action against Microsoft seeking more documents and interviews. Microsoft challenged the requests and argued that the use of Quinn was an improper delegation of a government function and raised taxpayer confidentiality and privacy concerns.
The IRS has faced criticism from the public and Congress for its use of an outside law firm in an audit. Top-ranking IRS officials recently stated that the IRS does not plan to use outside law firms in other audits.
Amazon's cost-sharing agreement to go on trial
Sometime in 2016, the Tax Court could issue an opinion in Amazon. Amazon.com, Inc. v. Commissioner, T.C. Dkt. 31197-12, involves a cost-sharing agreement with allocated amounts of over $1 billion for each of the two years in issue.
It involves some of the same issues that were litigated in Veritas v. Commissioner, 133 T.C. 297 (2009), nonacq, which is cited in Amazon's Tax Court petition. The IRS designated Amazon for trial.
In Guidant LLC v. Commissioner, Docket Nos. 5989-11, 5990-11, 10985-11, 26876-11, 5501-12, and 5502-12 (February 29 2016), the Tax Court denied the taxpayer's motion for summary judgment and held that the IRS's § 482 adjustments are not arbitrary, capricious, and unreasonable as a matter of law.
Guidant involves a group of US corporations that filed consolidated federal income tax returns. The IRS's § 482 adjustments involve transactions between the US consolidated group members and foreign distribution affiliates in Ireland and Puerto Rico.
The IRS asserted an adjustment to the taxpayer's income under § 482 without making specific adjustments to any of the subsidiaries' separate taxable incomes. The IRS also did not make specific adjustments for each separate transaction, but rather asserted an aggregated transfer pricing adjustment. The taxpayer filed a motion for a partial summary judgment asserting that the IRS did not determine "true taxable income" of each controlled taxpayer as required under Treasury Regulations § 1.482-1(f)(iv), and did not make specific adjustments with respect to each transaction. The court rejected both arguments.
While the court stated that Treasury Regulations § 1.482-1(f)(1)(iv) require the IRS to determine both consolidated taxable income and separate taxable income when making a § 482 adjustment with respect to income reported on a consolidated return, the court held that as a matter of law the IRS can assert a § 482 adjustment before it determines the separate taxable income.
The court stated that whether the IRS's decision to delay the separate-company taxable income computations constitutes an abuse of discretion under these circumstances is still in dispute and remains to be determined on the basis of the full record as developed at trial. Thus, the court did not conclusively hold that the IRS's § 482 adjustments were not arbitrary, capricious or unreasonable as a matter of fact. It only held that the IRS's § 482 adjustments were not arbitrary, capricious, or unreasonable as a matter of law.
The taxpayer subsequently entered into a settlement on favorable terms for the 2001-2007 tax years for a small percentage of the original determination. The IRS also agreed to concede alternative adjustments under § 367(d).
|Andrew Kim and Larissa Neumann|
Fenwick & West
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