The U.S. Tax Court recently decided for the taxpayer in a $2 billion transfer pricing adjustment imposed by the IRS [Medtronic, Inc. v. Commissioner, T.C., No. 6944-11, T.C. Memo No. 2016-112]. At issue was the pricing of two licenses – one in respect of medical device technology, and one covering the Medtronic names and marks – and which transfer pricing method is the best method to apply under Treasury Regulations § 1.482-4.
Medtronic took the approach of looking to uncontrolled licensing transactions for support in applying the Comparable Uncontrolled Transaction (CUT) method, while the IRS used the Residual Profit Split Method (PSM). Broadly speaking, the CUT prices the transaction directly in a manner that follows how most third parties make IP deals. The PSM, on the other hand, splits the system or joint profit left over after allocating a basic return to the contributions of the transaction participants. The art in the PSM is deciding how most reliably to split the profit that’s left over – a value that can be large where valuable intangible assets are used in a business at scale. Reasonable people can disagree over works of art.
The difference between the outcomes of two approaches was colossal (no, that 59% royalty rate was not a typo), even after the dispute had been through the IRS audit process for some time. To an experienced transfer pricing economist, a large difference in the results obtained from more than one transfer pricing method means only one thing. An error or errors, a questionable assumption, a data problem, or incomplete information. In this instance, the experts for the petitioner and the respondent were not of much help to the judge in exposing the reasons for the gap between the two positions. The judge was left to go back to the complex facts and make her own decision – as has been the case in other transfer pricing trials.
Without spending considerable time determining whether the taxpayer’s approach was reasonable, the decision dismantles the IRS PSM analysis thoroughly, relying on the facts rather than the assumed consequences of company characterization clichés – “contract manufacturer”, “limited risk”, “routine intangibles”, etc.
The decision sounds a warning for those currently parroting the undefined OECD term “value creation” as a determinant of the location of company profit. The court found the IRS “value chain” analysis to have no standing as a transfer pricing method, and relied on a misinterpretation the business facts to fit the theory of the PSM approach. Alternatively, the decision evaluates what attributes made Medtronic’s products worth purchasing and paying for (and also less worth purchasing and paying for) to its physician and patient customers. A causal connection was found between market share and market pricing, product quality outcomes, and the companies, departments and employees that contributed to an effective and safe product, final assembly and product sterilization, final quality checks. The decision also carefully identified which companies incurred losses when implanted products failed or were recalled, and used this information in its comparability analysis.
Underlining the importance of good intercompany agreements, the decision relied on the intercompany contracts the parties had concluded to explain their responsibilities and the division of liability in the event of a quality problem. The contracts could be relied on, as the contractual terms matched the actions of the parties.
This taxpayer win, which may yet be appealed, is instructive for companies that must perform a best method analysis under US tax law, encouraging to companies now experiencing an unexplained IRS breach of an agreement on the method of determining true taxable income, and foreshadows the release of controversial OECD guidance on the application of profit split transfer pricing methods.
TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.