US Eighth Circuit vacates Tax Court opinion in Medtronic, remands to Tax Court for further consideration

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1 29 August 2018 Global Tax Alert News from Transfer Pricing US Eighth Circuit vacates Tax Court opinion in Medtronic, remands to Tax Court for further consideration NEW! EY Tax News Update: Global Edition EY s new Tax News Update: Global Edition is a free, personalized subscription service that allows you to receive EY Global Tax Alerts, newsletters, events, and thought leadership published across all areas of tax. Access more information about the tool and registration here. Also available is our EY Global Tax Alert Library on ey.com. Executive summary On 16 August 2018, a three-judge panel of the United States (US) Eighth Circuit Court of Appeals vacated the Tax Court opinion in Medtronic v. Comm r, T.C. Memo (2016). The Tax Court had rejected the transfer pricing analysis prepared by both the Internal Revenue Service (Service) and Medtronic Inc. (Medtronic US) and, instead, rendered a decision based on its own determination of the arm s-length result. The majority Eighth Circuit opinion concluded that the Tax Court opinion failed to provide sufficient factual findings to enable the appellate court to evaluate the Tax Court s determination of the arm s-length result. Therefore, the Eighth Circuit vacated the Tax Court opinion and remanded the case to the Tax Court for reconsideration in light of the views set forth in this [the Eighth Circuit s] opinion. Detailed discussion Medtronic US is the parent company of a global medical device company that manufactures and sells implantable medical devices. Medtronic US entered into a licensing agreement (the Licensing Agreement) with its Puerto Rican subsidiary (MPROC) to manufacture medical devices (devices and leads). The Licensing Agreement established royalties to be paid by MPROC to Medtronic US for certain intangible assets used by MPROC for further development,

2 2 International Tax Alert News from Transfer Pricing manufacturing and commercialization of the medical devices and leads. As part of the Licensing Agreement, MPROC was responsible for bearing product liability expenses associated with the products it manufactured. Based on an analysis using the Comparable Profits Method, the Service concluded that the royalties paid by MPROC were not arm s length and should be increased. The Tax Court criticized the Service s method for: (1) failing to give enough weight to MPROC s quality control function; (2) using comparable companies that differed significantly from MPROC by manufacturing dissimilar devices on a smaller scale and engaging in functions in which MPROC did not engage; (3) using a profit level indicator that did not adequately capture the return to certain assets not carried on the MPROC balance sheet; and (4) analyzing certain functions on an aggregate basis that should have been analyzed separately. The Tax Court also concluded that Medtronic US s application of the comparable uncontrolled transaction (CUT) method to the Licensing Agreement had deficiencies. Medtronic US s CUT analysis was based on several uncontrolled comparables, of which the Tax Court placed the most emphasis on an agreement in which Medtronic US and another company agreed to cross-license certain intangibles (the Pacesetter Agreement). In rejecting the CUT analysis, the Tax Court highlighted differences between the transaction features in the CUT set, and those at issue at trial, including: (1) the instant case involved a broader array of devices than the Pacesetter Agreement; (2) Medtronic US s expert failed to analyze devices and leads separately when making adjustments to the rates in the Pacesetter Agreement; (3) the Pacesetter Agreement included some of the same, but also different, intangibles; and (4) the Pacesetter Agreement came about as a result of litigation. The Tax Court further criticized Medtronic US s expert s analysis for failing to include a profit-potential analysis. For all of the foregoing reasons, the Tax Court also rejected Medtronic US s method, and found that it had not met its burden of proving that its CUT methodology produced an arm s-length result. The Tax Court, therefore, undertook its own transfer pricing analysis based on the CUT method, treating the Pacesetter Agreement as the best comparable available for calculating an arm s-length result. The Tax Court rejected the Service s contention that appropriate adjustments could not be made to the Pacesetter Agreement. Accordingly, the Tax Court used the adjusted royalty rate of Medtronic US s expert as a starting point, and made several adjustments for know-how, profit potential, and the fact that the Pacesetter Agreement only involved Cardiac Rhythm Disease management (CRDM) technology, while the Licensing Agreement involved both CRDM and neurological technology. After making all of the various adjustments, the Tax Court arrived at a wholesale royalty rate of 44% for devices licenses. Further, because the devices business was significantly more profitable than the leads business, the Tax Court concluded that a royalty rate of 22% for leads licenses was reasonable. The majority Eighth Circuit opinion concluded that the Tax Court opinion failed to provide sufficient factual findings to enable the appellate court to evaluate the Tax Court s determination of the arm s-length result. The Eighth Circuit s opinion noted that the Tax Court did not address in sufficient detail the comparability of the Pacesetter Agreement and the Licensing Agreement, given that the former had arisen as a settlement of litigation. The Eighth Circuit opinion also noted that the Tax Court opinion did not address the comparability of the contractual terms (including terms related to the intangibles covered) of the Licensing Agreement and the Pacesetter Agreement, and did not decide how risk and product liability expenses should be allocated between Medtronic US and its subsidiary. Consequently, the Eighth Circuit concluded it had insufficient information to review the Tax Court s opinion, and so vacated the opinion and remanded the case to the Tax Court for reconsideration. Following the Eighth Circuit Opinion, the Tax Court will need to address the deficiencies raised by the Eighth Circuit or the Tax Court opinion will remain vacated.

3 International Tax Alert News from Transfer Pricing 3 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, US Transfer Pricing Controversy Services David Canale, Washington, DC david.canale@ey.com Peter Griffin, Minneapolis peter.griffin@ey.com Tracee Fultz, New York tracee.fultz@ey.com Ken Christman, Washington, DC kenneth.christmanjr@ey.com

4 4 International Tax Alert News from Transfer Pricing Ernst & Young LLP, International Tax Services US Transfer Pricing Controversy Services David Canale Ken Christman kenneth.christmanjr.com David Farhat Hiro Furuya Peter Griffin Ameet Kapoor Dan Karen Carlos Mallo Dick McAlonan Mike McDonald Tom Ralph Craig Sharon Tom Vidano Miller Williams Transfer Pricing leaders Ernst & Young LLP, Minneapolis Peter Griffin Tracee Fultz, New York Ernst & Young LLP (Canada), Ottawa Tom Tsiopoulos Mancera, S.C., Mexico City Enrique Gonzalez Ernst & Young Ltda., Bogota Andres Parra Kost Forer Gabbay & Kasierer, Tel Aviv Lior Harary-Nitzan Ernst & Young LLP, US Area Leaders Larry Eyinla, Atlanta Colleen Warner, Chicago Lonnie Brist, Houston Barbara Mace, New York (Financial Services) Anne Welsh, Seattle David Canale, Washington, DC (National Tax) Dick McAlonan, Washington, DC (National Tax)

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