Medtronic Battle With IRS Underscores Transfer Pricing Obstacles

Medtronic Inc. v. Commissioner, an ongoing eight-year tax battle between a medical-device manufacturer and the IRS, highlights the challenges of selecting the best transfer pricing method, particularly when dealing with transfers of intangible property.

The dispute involves the pricing of licenses between Medtronic, a US-based parent company, and its subsidiary, Medtronic Puerto Rico Operations Co. The IRS argues that the royalty payments made by MPROC, the subsidiary, were too low.

The case has been in litigation since 2016 and, for the second time, is before the US Court of Appeals for the Eighth Circuit, where the IRS is arguing the Tax Court’s 2022 ruling violates Section 482 of the tax code for pricing intangibles.

Regulations under Section 482 stipulate that the Tax Court select the “best method” to price Medtronic’s intangibles. The IRS says the court should have recognized its proposal, the comparable profits method, as more reliable for pricing intercompany transactions than Medtronic’s proposal, which isn’t specified in the Treasury regulations.

The series of decisions from the Tax Court and Eighth Circuit since 2016 cast doubt on the utility of using Medtronic’s preferred comparable uncontrolled transaction, or CUT, method in transfer pricing. The case highlights the problem of finding reliable CUTs to benchmark unique and high-value intangible assets and complex value chains.

Transfer pricing regulations require companies to make comparability adjustments to a CUT for differences in profit potential, risk, and functions between controlled and uncontrolled transactions. However, these adjustments cumulatively risk fabricating a transaction that no longer resembles the original uncontrolled transaction.

Because such modifications are inevitably judgmental, the outcome is often contentious. Not only did Medtronic and the Tax Court in 2022 make large-scale alterations to a 1992 agreement with Siemens Pacesetter, but there’s uncertainty about the agreement’s qualification as a valid foundation for application of the CUT method.

With the CUT method wounded, arguably fatally, where does this leave taxpayers, pending a decision on the IRS’s appeal? The Tax Court in 2016 criticized the IRS’s application of the comparable profits method for undervaluing MPROC’s quality control function; selecting companies not comparable in terms of product, scale, or functionality; overlooking assets absent from MPROC’s balance sheet; and improperly analyzing certain functions in aggregate rather than piecemeal.

Questionable application of the comparable profits method is similarly central to Amgen’s appeal of its income tax assessment relating to its manufacturing in Puerto Rico.

Nevertheless, such critiques don’t close the door to a more robust application of the comparable profits method, especially as it doesn’t require the austere comparability criteria of the CUT method. Could the IRS, for example, have identified closer comparable companies, at least in terms of the key value drivers claimed for MPROC?

The comparable profits method, and its sister, the OECD’s transactional net margin method, are widely applied and can be found in almost all countries’ transfer pricing regulations. The profit split method is another viable option, as it enables taxpayers to capture the value drivers on both sides of an intercompany transaction. In the Medtronic case, the argument hinged on whether and to what degree both Medtronic and MPROC have valuable, non-routine intangibles.

Admittedly, determining the relative value of intangibles is seldom straightforward and can be contentious, but the profit split method is widely used and respected globally.

The Tax Court’s adoption of an unspecified method shouldn’t be viewed as a panacea. Unspecified methods are seldom seen in practice and will attract scrutiny from tax authorities. By combining the CUT method, the comparable profits method, and an unexplained residual profit split, the Tax Court didn’t offer taxpayers a clear roadmap to determining the best method in general.

To many, the Tax Court’s approach may seem like an arbitrary hybrid. Is the key takeaway from its decision that other taxpayers involved in such transactions should construct their own unspecified methods?

Perhaps the most prudent path is for taxpayers involved in complex transactions to prepare transfer pricing studies that, while presenting the best method, offer alternative methods as corroboration. Demonstrating that a taxpayer’s results can be achieved using multiple methods, reliably adjusted, would strengthen the basis for supporting the arm’s-length nature of the transactions.

The fact that Medtronic and the IRS selected drastically different methods, with very different results, set the stage for this long-running court battle—an outcome most taxpayers would prefer to avoid.

The case is Medtronic, Inc. v. Commissioner, 8th Cir., No. 23-03281, brief filed 2/16/24.

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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