Medtronic Battle Makes One Transfer Pricing Method a Safer Bet

The weight of regulations appears to lie in favor of the IRS in Medtronic v. Commissioner, an ongoing eight-year transfer pricing battle between a medical-device manufacturer and the government.

But with the outcome of the case in the air, taxpayers would be wise to consider using the comparable profits method for transfer pricing involving intangible property. This system, known as CPM, determines transfer prices by comparing profitability results from similar taxpayers performing similar activities under similar circumstances.

Taxpayers should be wary of relying solely on comparable uncontrolled transactions, or CUTs, when considering transfers of unique or highly valuable intangible property.

And if there are valuable intangibles on both sides of the intangible property transaction, the profit split method may offer a viable alternative or corroborative method.

The profit split method, CUT method, and CPM are among the main methods used by multinational enterprises and tax administrations for transfer pricing, which refers to the way in which companies value their transactions between related entities.

Issues at Stake

The ongoing Medtronic case, pending in the US Court of Appeals for the Eighth Circuit, involves the licensing of intangibles by Medtronic to Medtronic Puerto Rico Operations Co., or MRPOC, for the manufacturing of medical devices and leads.

The central issue remains how to determine the best method to price intercompany licenses. Both sides have appealed the Tax Court’s ruling for different reasons, with the IRS contesting the rejection of its application of the CPM and Medtronic challenging the reversal of the initial decision to uphold the use of the CUT method.

Section 482 of the tax code provides various methods to determine arm’s-length prices, each with its own eligibility criteria. Contrary to Medtronic’s assertion in its opening brief, the regulations don’t prioritize any specific transfer pricing method and haven’t for decades.

The best method rule replaced the hierarchy of methods under previous regulations, as confirmed in the Federal Register in 1994, and requires that the arm’s-length result be determined using the method that provides the most reliable measure of an arm’s-length result, based on the facts and circumstances.

The CUT method could be the most reliable method, but only if the strict comparability requirements outlined in the regulations are met, and when no other method is more reliable.

The IRS contends that Medtronic’s third-party pacesetter agreement can’t be used as direct evidence of an arm’s-length price for the intangibles provided to MPROC. The IRS claims the MPROC licenses encompassed a broad range of materially different intangible assets—such as know-how, regulatory approvals, trade secrets, copyrights, and patents—while the pacesetter agreement licensed only patents.

The profit potential of just patents is unlikely to come anywhere close to that of the basket of intangibles (including patents) licensed to MPROC, which arguably provide all the necessary intangible property for the production and sales of the devices and leads. Because one of the comparability criteria for the CUT method is the profit potential of the intangibles, it is hard to see how the pacesetter agreement provides any meaningful indication of how to benchmark the MPROC intangibles.

The Tax Court has emphasized that the most reliable transfer pricing method for high-value intangibles, like those in Medtronic, often avoids direct valuation of those assets. The CPM applied by the Tax Court in Coca-Cola Co. v. Commissioner demonstrated this.

The CUT method is seldom the most reliable formula for high-value intangibles, such as intangible property, as there are typically no comparable uncontrolled transactions for unique assets. Congress recognized this when it amended Section 482 and instructed the Treasury Department to explore alternative valuation methods, such as the CPM.

Outlook

Until this case is resolved, taxpayers may understandably wonder about the best way to benchmark transfers of intangibles. The CPM remains the most applied best method in transfer pricing globally. Although its application by the IRS in Medtronic could have used some refinement, taxpayers would be prudent to model out what a CPM result might be, even if they prefer to present the CUT method as their primary method when transferring unique or highly valuable intangibles.

The case is Medtronic Inc. v. Commissioner, 8th Cir., 23-3063 and 23-328, 2/15/24.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Vernon Noronha is director at Moss Adams with expertise in transfer pricing services across a range of industries.

Felicita Moreno-Stevens is a senior associate at Moss Adams with focus on transfer pricing implications and strategies related to IP valuation and relevant tax laws and regulations.

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