Medtronic versus the Commissioner of the Internal Revenue Service
Intangible Assets and Transfer Pricing: The Medtronic Case
- IRS provided Medtronic, a manufacturer of pacemakers and other medical equipment, a notice of deficiency of $1.4 billion for the tax years 2005 and 2006. The issue was the treatment and valuation of royalty payments to Medtronic’s affiliate MPROC.
- The IRS calculated the deficiency using the comparable profits method (CPM), which had not been the standard in the negotiation of a previous memorandum of understanding (MOU) between the IRS and Medtronic that had governed royalty payments. The MOU used the comparable uncontrolled transaction method (CUT) in its evaluation and Medtronic retained that method in their argument before the Tax Court. The effect of using CPM had allowed the IRS to ignore certain economically valuable benefits to four licensing agreements between Medtronic and MPROC, and to disregard MPROC’s important responsibility to maintain product quality control in determining the transfer pricing tax. The Tax Court ruled that the IRS had been “arbitrary, capricious and unreasonable” in their revaluation of royalty payments and in the notice of deficiency.
- While the Tax Court determined that the CUT method was more appropriate in the Medtronic case, it felt the royalty payments needed to be adjusted to reflect a realistic valuation of licensing agreements and their effect upon the economic relationship between Medtronic and MPROC. The Court determined that the specific CUT yardstick Medtronic used, an agreement between Medtronic and Siemen’s Pacesetter, was inaccurate due to the discrepancy between Siemen’s licensing agreements and those agreements with MPROC. Ultimately, the Court determined that the royalty rate should be 44 percent for devices and 22 percent for leads.
Transfer pricing disputes and the eye of the beholder
What makes international disputes regarding transfer prices so difficult is the “eye of the beholder” aspect evident in many of them. Tax authorities must prove that the price charged for assets transferred within a corporate group is substantially inconsistent with the price charged in an “arm’s length” transaction between two unrelated companies. This is particularly difficult when the assets in dispute are intangibles unique to a corporate group. But the OECD base erosion and profit shifting initiative places emphasis on transfer pricing abuse in general and intangibles in particular. Of the 15 BEPS Actions, three of them confront transfer pricing abuse with one addressing intangibles:
“Action 8 addresses transfer pricing issues relating to controlled transactions involving intangibles since intangibles are by definition mobile and they are often hard-to-value. Misallocation of the profits generated by valuable intangibles has heavily contributed to base erosion and profit shifting.” [OECD BEPS Action 8]
Medtronic is an international medical equipment manufacturer producing world-class pacemakers and the electronic leads that connect the pacemakers to patients’ hearts, among many other products. In 2010, the IRS provided a notice of deficiency for 2005 and 2006, based upon a 2007 audit. The tax agency claimed that Medtronic violated a 2002 memorandum of understanding (MOU) regarding the royalty rate for MPROC, a Medtronic manufacturing entity based in Puerto Rico, and Medtronic USA. The MOU increased the royalty rate on devices to 44 percent and on leads to 26 percent. However, for the purposes of the notice of deficiency, the IRS used the comparable profits method to set royalty rates for devices and leads manufactured at MPROC. The result was that the tax deficiencies for 2005 and 2006 were found to be $548,180,115 and $810,301,695, respectively.
In a 2016 opinion, the US Tax Court agreed with Medtronic that the IRS application of the comparable profits method of determining transfer prices for devices and leads was arbitrary, capricious and unreasonable. However, the Court also found that the alternative proposed by Medtronic, the comparable uncontrolled transaction method (CUT) favored the company too much and needed to be adjusted to more accurately reflect transfer prices for devices and leads.
Coming to an agreement about the appropriate method for determining the royalty rate
This is essentially where the case begins: the IRS method was determined by the court to apply an “arbitrary and capricious” new pricing standard, but the alternative CUT proposal was found to be inaccurate by the court. The real dilemma before the US Tax Court gets at the heart of the difficulty of reining in transfer pricing abuse with a group: what would a “more accurate” pricing standard look like and how would it be developed?
To understand the complexity of the case and the difficulty in setting a fair transfer price, it is necessary to look at the industry in which Medtronic competes and their specific business practices.
Medtronic business lines for Cardiac Rhythm Disease Management (CRDM) and Neurological (Neuro) are both involved in the design and manufacture of devices and electrical leads implanted in the body. Therefore, product quality, and the quality assurance process, are paramount to the company’s profits, sales and brand. Medtronic US handled research and development, clinical studies of devices, quality control, and regulatory compliance.
MPROC was a Medtronic affiliate manufacturing class II and class III medical devices to FDA standards and responsible for quality compliance. Class III devices are that are life-sustaining and require premarket approval from the FDA, an exacting and rigorous standard. Manufacturing these devices requires skill and care, and class II devices, such as the leads manufactured by Neuro, in bulk also required adherence to the strictest standards of quality. The process in MPROC required both manual and automated steps and it could take up to two weeks to complete a single device. Manufacturing the leads, though made in bulk, primarily required manual work. There were multiple quality inspections throughout the manufacturing.
This emphasis on quality was critical to the royalty rates paid by MPROC to Medtronic. Five company agreements for intangibles used in manufacturing these, and other, devices were exclusively licensed to MPROC by Medtronic. One agreement made MPROC exclusively responsible for quality and regulatory compliance. The second licensing agreement was a component supply agreement whereby MPROC would buy certain components from Medtronic and its subsidiaries, one effect of which was to limit Medtronic’s product liability exposure to the purchase price of those components. The third agreement made Med USA, another affiliate of Medtronic, the exclusive distributor for MPROC devices in the US, and leads in the US and elsewhere. The agreement effectively protected Med USA against any product liability. The fourth license permitted MPROC to use valuable intangibles like trademarks and tradenames in the US to sell devices, and to sell leads worldwide, in exchange for certain royalties. The fifth licensing agreement was not relevant to this case.
One effect of the first three agreements was to shift product liability risk away from Medtronic and Med USA, a strategically important and valuable activity with manufactured devices implanted in the human body, and significant in setting royalty rates from paid by MPROC to Medtronic. Therefore, these licensing agreements were at the center of the transfer pricing dispute between Medtronic and the IRS. MPROC’s assumption of risk should reasonably be reflected in a lower royalty rate paid by MPROC for devices they manufactured for Medtronic.
Licensing agreements were at the heart of the conflict in valuation
It was clear as the case proceeded that the four licensing agreements were at the heart of the disagreement between the IRS and Medtronic. The “eye of the beholder” effect created radically different analyses of MPROC’s role in the manufacturing and quality control of Medtronic products and that resulted in the $1.4 billion notice of deficiency for 2005 and 2006.
It was the IRS conclusion, based on an economic analysis, that MPROC was essentially a finished product manufacturer whose function could have been done by a vendor, and MPROC did not provide enough value-added to warrant a significantly lower royalty rate. As for the four licensing agreements used by MPROC, they were held by Medtronic and the economic value of risk management was open to interpretation. Medtronic preferred to price the economic effect of each licensing agreement, but the IRS preferred a functional analysis that viewed the agreements in the aggregate, analyzed the group’s operations as a series of functional steps, and assessed the value of each step.
The net effect, as well as the IRS’s reliance on the comparable profits method, which compared other groups to determine if MPROC’s profits were reasonable, was to undercut the value of the quality control function – such an acute part of Medtronics/MPROC’s business model — and negate the economic effects of the risk management strategy contained within the licensing agreements. The Tax Court took issue with both aspects of the IRS’s economic analysis. The comparison groups were deemed significantly different, and the return on assets and profit level metrics used to evaluate MPROC were imprecise and misleading, the Court determined., as well as the IRS aggregation of the four licensing agreements. The Tax Court found the IRS’s actions were arbitrary, capricious, and unreasonable for these reasons.
However, the Tax Court also took issue with how Medtronic’s expert valued the four licensing agreements and how he had applied the comparable uncontrolled transaction method of evaluating the royalty rate between Medtronic and MPROC. Again, licensing agreements were at the heart of the Court’s disagreement with the company: while it found the trademark agreement fell above the arm’s length threshold, Medtronic had failed to account for the differences between licensing agreements between the company and Siemen’s Pacesetter, the transaction Medtronic used as its comparable uncontrolled transaction.
The Tax Court decided the CUT method was the most appropriate analysis to determine a reasonable royalty rate for MPROC, but felt it needed to be adjusted. An important adjustment was to account for quality control and design changes as a collaborative effort and adjust the royalty rate accordingly. Ultimately, a 44 percent royalty rate for devices and a 22 percent royalty rate for leads was determined to be appropriate by the Court. (The Court also said the correlation between these rates and those of the original MOU – 44 percent and 26 percent – was irrelevant and purely coincidental.)
The IRS appealed the ruling to the US Court of Appeals for the Eighth Circuit, which found the Tax Court’s adjustments relevant to the Pacesetter agreement were not appropriate. The case will return to Tax Court in April 20220. The proceedings will hear from experts whether the CUT method, as adjusted by the court, is the most appropriate yardstick and whether the Siemen’s Pacesetter/Medtronic agreement is an appropriate CUT given the substantive discontinuity between Siemen’s-Medtronic licensing agreements and Medtronic-MPRO licensing agreements.