The Tax Court in Brief – August 15th – August 19th, 2022
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Tax Litigation: The Week of August 15th, 2022, through August 19th, 2022
Medtronic, Inc. v. Comm’r, T.C. Memo. 2022-84 | August 18, 2022 | Kerrigan, J. | Dkt. No. 6944-11.
Short Summary: This opinion regards a transfer pricing, comparable uncontrolled transaction (“CUT”), comparable profits method (“CMP”), and deficiencies in tax totaling approximately $548,180,115 for 2005 and $810,301,695 for 2006 against taxpayer Medtronic, Inc. and its consolidated affiliates. The underlying transactions—being the transactions for which deficiencies were determined—stemmed from a long history of third-party settlement agreements in medical device patent litigation, assignments of patent royalty rights, related-company agreements and licenses and valuation of consideration exchanged in those agreements for, but not limited to, patents, royalties, litigation settlements, product liability risk assumptions, self-insurance risks, and other.
Procedurally, the case regards a remand from the U.S. Court of Appeals for the Eighth Circuit for further consideration of prior Tax Court opinion in Medtronic, Inc. v. Commissioner (Medtronic I), T.C. Memo. 2016-112, vacated and remanded Medtronic, Inc. v. Commissioner (Medtronic II), 900 F.3d 610 (8th Cir. 2018). Basically, the Circuit Court concluded that the factual findings from the previous Tax Court opinion were insufficient to enable the Circuit Court to conduct an evaluation of the Tax Court’s determination about the CUT in issue, so the Circuit Court remanded to the Tax Court for further factual development.
In turn, the Tax Court provided this 75-page memorandum opinion heavily focused on facts and evidence, including testimony from 10 expert witnesses, and complex evaluation of 26 U.S.C. § 482 and related Treasury Regulations, 26 C.F.R. § 1.482-1, et. seq., to horizontal and vertical transactions involving transfer pricing, CUTs, and CMP permitted by the Internal Revenue Code and Treasury Regulations.
This Tax Court in Brief provides a succinct summation of the tax laws in issue. For more detailed application of the law to the facts in issue, please see the opinion itself.
Under section 482 and related Treasury Regulations, what is the proper method for determining the arm’s-length rate to be applied to the transactions in issue, including for royalty payments and other consideration exchanged between Medtronic and its related companies?
Medtronic did not meet its burden to show that its proposed allocation under the CUT method and its proposed “unspecified method” satisfy the arm’s-length standard. The Tax Court determined that, of the five general comparability factors applied to the agreements presented for comparison by Medtronic, the functions, economic conditions, and property or services were not comparable, and thus, the proposed comparable agreement was not a CUT. The comparison required too many adjustments.
Also, the IRS’s modified CPM resulted in an abuse of discretion. The CPM proposed by the IRS resulted in skewed comparison of medical devices, an unrealistic profit split and too high a royalty rate, and the IRS’s adjustment for product liability was deemed inadequate based on the evidence presented. Thus, the IRS’s determination based on the modified CPM presented constituted an abuse of discretion.
If neither party has proposed a method that constitutes “the best method,” the Tax Court must determine from the record the proper allocation of income. Therefore, pursuant to section 482 of the Internal Revenue Code and related Treasury Regulations, the Tax Court—taking somewhat of a blend of the available methods and evidence presented— applied what it believed was the “best method” for arriving at appropriate allocation and royalty rate to be applied to the related-party intellectual property agreements and royalty rates made the basis thereof. By this approach, the Tax Court sought to bridge the gap between the section 482 methods presented by Medtronic and the IRS.
Key Points of Law:
26 U.S.C. § 482—Allocation of income and deductions among taxpayers. “In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 367(d)(4)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.” (emphasis added).
Section 482 was enacted to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). Section 482 gives the IRS broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations are necessary either to prevent evasion of tax or to reflect clearly the income of the corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149, 163 (1994).
Standard of Review. When the IRS has determined deficiencies based on section 482, the taxpayer bears the burden of showing that the allocations assigned by the IRS are arbitrary, capricious, or unreasonable. See Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353 (1991). The IRS’s section 482 determination must be sustained absent a showing of abuse of discretion. See Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989), aff’d, 933 F.2d 1084 (2d Cir. 1991). “Whether respondent [IRS Commissioner] has exceeded his discretion is a question of fact. . . . In reviewing the reasonableness of respondent’s determination, the Court focuses on the reasonableness of the result, not on the details of the methodology used.” Sundstrand Corp., 96 T.C. at 353–54; see also Terrazzo Strip Co. v. Commissioner, 56 T.C. 961, 971 (1971). The regulations provide that when determining which method provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are (1) the degree of comparability between the controlled transaction (taxpayer) and any uncontrolled comparables and (2) the quality of the data and assumptions used in the analysis. Treas. Reg. § 1.482-1(c)(2).
IRS Evaluation of a Section 482 Transaction. The IRS will evaluate the results of a transaction as actually structured by the taxpayer unless it lacks economic substance. Reg. § 1.482-1(f)(2)(ii)(A). Treasury Regulation § 1.482-1(d)(4)(iii)(A)(1) provides that transactions “ordinarily will not constitute reliable measures of an arm’s length result” if they are “not made in the ordinary course of business.” However, the IRS may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under similar circumstances. Id. Thus, the IRS may adjust the consideration charged in the controlled transaction according to the cost or profit of an alternative, but the IRS will not restructure the transaction as if the taxpayer had used the alternative. See id. To determine “true taxable income,” the standard to be applied is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Id. para. (b)(1).
As in effect during 2005 through 2006, the Treasury Regulations provided four methods to determine the arm’s-length amount to be charged in a controlled transfer of intangible property: the CUT method, the CPM, the profit split method, and unspecified methods as described in Treasury Regulation § 1.482-4(d). See id. 1.482-4(a).
The best method rule provides that the arm’s-length result of a controlled transaction must be determined using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. Id. § 1.482-1(c)(1). There is no strict priority of methods, and no method will invariably be considered more reliable than another. Id. In determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of data and assumptions used in the analysis. Id. subpara. (2); see also Reg. §§ 1.482– 1(c)(1), 1.482-4(a); Coca-Cola Co. & Subs. v. Commissioner, 155 T.C. 145, 211-12 (2020).
If neither party has proposed a method that constitutes “the best method,” the Tax Court must determine from the record the proper allocation of income. Sundstrand Corp. & Subs., 96 T.C. at 393. In transfer pricing cases it is not unique for the Tax Court to be required to determine the proper transfer pricing method. See Perkin-Elmer Corp. & Subs. v. Commissioner, T.C. Memo. 1993-414.
The CPM evaluates whether the amount charged in a controlled transaction is arm’s length according to objective measures of profitability (profit level indicators) derived from transactions of uncontrolled taxpayers that engage in similar business activities under similar circumstances. 26 C.F.R. § 1.482-5(a) (comparable profits method). Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. Id. para. (b)(4). The profit level indicator depends upon a number of factors, including the nature of the activities of the tested party, the reliability of available data with respect to uncontrolled comparables, and the extent to which the profit level indicator is likely to produce a reliable measurement of the income that the tested party would have earned had it dealt with controlled taxpayers at arm’s length, taking into account all facts and circumstances. Id.; see also Coca-Cola Co. & Subs., 155 T.C. at 210–13, 221–37.
An additional CPM method is a cost-plus method, which is used for cases involving the manufacture, assembly, or other production of goods sold solely to related parties. See Reg. § 1.482-3(d)(1).
The CPM benchmarks the arm’s-length level of operating profits earned by the tested party with reference to the level of operating profits earned by comparable companies. See Reg. § 1.482-5(b)(1).
CUT Method. The CUT method evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction. Reg. § 1.482-4(c)(1). If an uncontrolled transaction involves the transfer of the same intangible under the same or substantially the same circumstances as the controlled transaction, the results derived generally will be the most direct and reliable measure of the arm’s-length result for the controlled transfer of an intangible. Id. subpara. (2)(ii). The CUT method requires that the controlled and uncontrolled transactions involve the same intangible property or comparable intangible property as defined in the Treasury Regulations. Id. subdiv. (iii)(A). To be considered comparable, both intangibles must (i) be used in connection with similar products or processes within the same general industry or market and (ii) have similar profit potential. Id. subdiv. (iii)(B)(1). The profit potential of an intangible is most reliably measured by directly calculating the net present value of the benefits to be realized (on the basis of prospective profits to be realized or costs to be saved) through the use or subsequent transfer of the intangible, considering the capital investment and startup expenses required, the risks to be assumed, and other relevant considerations. Id. subdiv. (iii)(B)(1)(ii).
A comparable with different royalty rate may serve “as a base from which to determine the arm’s-length consideration for the intangible property involved in this case.” Sundstrand Corp., 96 T.C. at 393.
Controlled and uncontrolled transactions must involve the same or comparable intangible property, and differences in contractual terms and economic conditions should be considered. See Reg. § 1.482-4(c)(2)(iii). The Treasury Regulations provide contractual and economic factors to assess the comparability of circumstances between a controlled and an uncontrolled transaction for the CUT method. See id. subdiv. (iii)(B)(2).
The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of Treasury Regulation § 1.482-1(d). Specified factors are particularly relevant to the CUT method. Treas. Reg. § 1.482-4(c)(2)(iii). Those factors are (1) functions, (2) contractual terms, (3) risks, (4) economic conditions, and (5) property or services. The application of the CUT method specifies that the controlled and uncontrolled transactions need not be identical but must be sufficiently similar that they provide an arm’s-length result. Id. subpara. (2). If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if they can be made with sufficient accuracy to improve the reliability of the results. Id. If adjustments for material differences cannot be made, the reliability of the analysis will be reduced. Id.
For intangible property to be considered comparable, the intangibles must be used in connection with similar products or processes within the same general industry or market and have similar profit potential. Id. § 1.482-4(c)(2)(iii)(B)(1). In evaluating the comparability of the circumstances of the controlled and uncontrolled transactions the following factors “may be particularly relevant”: (1) the terms of the transfer; (2) the stage of development of the intangible; (3) rights to receive updates, revisions, or modifications of the intangible; (4) the uniqueness of the property; (5) the duration of the license; (6) any economic and product liability risks; (7) the existence and extent of any collateral transactions or ongoing business relationships; (8) the functions to be performed by the transferor and transferee; and (9) the accuracy of the data and the reliability of assumptions used. Id. subdivs. (iii)(B)(2), (iv).
Profit Split Method. The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. Id. § 1.482-6(a). Allocation under the profit split method must be made in accordance with either the comparable profit split method or the residual profit split method. Id. para. (c)(1). The comparable profit split method is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business. Id. subpara. (2).
Unspecified Method. Methods not specified in paragraphs (a)(1), (2), and (3) of Treasury Regulation § 1.482-4 may be used to evaluate whether the amount charged in a controlled transaction is arm’s length. Any method used must be applied in accordance with the provisions of Treasury Regulation § 1.482-1. See Reg. § 1.482-4(d)(1). An unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. Id. An unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. Id. An unspecified method will not be applied unless it provides the most reliable measure of an arm’s-length result under the principles of the best method rule. Id.
“Commensurate with Income” – Difficulty in determining whether the arm’s length transfers of intellectual property between unrelated parties are comparable. Where taxpayers transfer intangibles with a high profit potential, the compensation for the intangibles should be greater than industry averages or norms. All facts and circumstances are considered in determining what pricing methods are appropriate in cases involving intangible property, including the extent to which the transferee bears real risks with respect to its ability to make a profit from the intangible or, instead, sells products produced with the intangible largely to related parties and has a market essentially dependent on, or assured by, such related parties’ marketing efforts. The profit or income stream generated by or associated with intangible property is to be given primary weight. The “commensurate with income” standard should be applied to work consistently with the arm’s-length standard.
For comparing two separate royalty-producing transactions for tax purposes under section 482, there must be enough similarities that the agreements can, at a minimum, be used as a starting point for determining a proper royalty rate. For example, if the terms of the payments are comparable, and if the compared agreements have similar royalty rates, the Tax Court may deem them appropriately comparable for evaluation under section 482. See Reg. § 1.482-4(c)(2)(iii); id. § 1.482-1(d)(3)(ii)(A)(1).
Generally, intangible property is considered comparable if it is used in connection with similar products. Treas. Reg. § 1.482– 4(c)(2)(iii)(B)(1)(i).
Allocation of Risks and Liabilities. Pursuant to the regulations “the consequent allocation of risks . . . that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions.” Treas. Reg. § 1.482-1(d)(3)(ii)(B)(1). The regulations specify that risks in this respect include product liability risks. Id. subdiv. (iii)(A)(5).
Best Method. An unspecified method will not be applied unless it provides the most reliable measure of an arm’s-length result under the principles of the best method rule. Treas. Reg. § 1.482– 4(d). Under the best method rule, the arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable method of getting an arm’s-length result. Id. § 1.482-1(c)(1).
Insight: This third iteration of Medtronic (Medtronic III, if you will) provides a comprehensive and fact-intensive example of how the Tax Court will evaluate a transaction for which allocations must be made under section 482 and related Treasury Regulations. The Tax Court here appeared to be extremely thorough and intellectually honest, noting that, after further trial and presentation of evidence following remand by the Eighth Circuit, some of the Tax Court’s findings in Medtronic I should be adjusted. And, the Tax Court appears confident in its leverage of the Treasury Regulations that permit the Tax Court to arrive at the best method when, as here, neither the taxpayer nor the IRS presented a method that was properly sustainable under section 482 and the related Treasury Regulations. In this remand proceeding, only Medtronic suggested a new method from what had been presented in earlier proceeding. While the Tax Court did not wholesale approve Medtronic’ new method, the Tax Court used that method, with adjustments, to arrive at an arm’s length allocation for federal income tax purposes. I suspect (or hope) the Court of Appeals for the Eighth Circuit will be satisfied with the Tax Court’s further development of facts and analysis of section 482 and its application to the transactions in issue.