Court opinion in transfer pricing case could have broad implications
Taxpayer favorable ruling provides transfer pricing insight
INSIGHT ARTICLE |
The Tax Court recently released its opinion in the transfer pricing case, Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue, that was tried in the spring of 2015. Judge Kathleen Kerrigan heard the case, and the court’s opinion provides some valuable insight into the proper approach to transfer pricing matters.
Consistent with U.S. transfer pricing regulations (primarily, section 482 and the corresponding Reg. section 1.482-1 et seq.), three main factors should be used to determine the appropriate allocation of profit between entities in an intercompany transaction:
- Functions performed
- Risks assumed
- Assets employed
The IRS and Medtronic considered all three factors in their arguments, but the crux of the disagreement between the two sides involved the appropriate characterization of the second factor (risks assumed). Essentially, the IRS argued risk of product success or failure (quality) was much less integral to Medtronic’s success than other factors (such as new product development, etc.). In contrast, Medtronic argued risk of product success or failure (quality) was of utmost importance to the success of the company. Ultimately, the court was not convinced by the IRS and (on this point) sided with the taxpayer.
This is an important distinction because it gives credence to risk as a determining factor in the appropriate allocation of profit in transfer pricing considerations. Functions performed and assets employed are important as well (and were considered in the analysis and opinion), but the decision speaks directly to risks assumed.
But the insight provided by the ruling does not end there for those navigating transfer pricing waters. After rejecting the IRS’s transfer pricing method, the court sided with Medtronic’s transfer pricing method—the comparable uncontrolled transaction (CUT) method. Under the CUT method, the profit earned in controlled, intercompany transactions is compared to the profit earned in comparable, uncontrolled transactions. If the profit of the intercompany transaction is consistent with the profit of the comparable, uncontrolled transactions (within certain parameters), the transfer pricing approach is considered to be consistent with the arm’s-length standard of U.S. regulations.
While the court agreed with Medtronic’s selection of the CUT method, it disagreed with Medtronic’s application of the method. Consequently, the court constructed its own application of the method which is outlined below.
- Medtronic used the CUT method to establish a range of royalties in its analysis
- Medtronic’s CUT method identified seven license agreements
- The court used one of these seven agreements to construct its own royalty
The use of one agreement in a CUT method application, generally, is considered less robust, but the court held the identified third party comparable (an agreement between Medtronic and a third party, Siemens Pacesetter, Inc. or Pacesetter) was appropriate to use as the base for its application of the CUT method.
The Pacesetter agreement outlined a 7 percent royalty on retail sales, which Medtronic adjusted for the following reasons.
- Exclusivity – the Pacesetter agreement was non-exclusive while the intercompany transaction in question was exclusive
- Exchange of knowledge regarding future products – the Pacesetter agreement did not necessarily include this exchange of knowledge for future products while it was considered presumed in the intercompany context
- Wholesale level adjustment – the Pacesetter agreement royalty was based on retail sale of the products and the intercompany agreement was based on wholesale sale of the products
The exclusivity adjustment applied by Medtronic increased the royalty by 7 percent and the future knowledge adjustment applied by Medtronic increased the royalty by 3 percent. The court’s opinion did not provide the direct calculation of the wholesale adjustment, but it seems to increase the retail royalty rate by a factor of about 1.5 times the rate.
The court used the 17 percent base retail royalty rate (7+7+3=17) calculated by Medtronic as a starting point, then made the following adjustments:
- Know-how – increased royalty by 7 percent for the access to know-how enjoyed in the intercompany context but not enjoyed in the Pacesetter context
- Profit potential – increased royalty by 3.5 percent for profit potential, which was deemed by the court to be greater in the intercompany context than in the Pacesetter context
- Scope of products – increased royalty by 2.5 percent for scope of products included in the intercompany context but not in the Pacesetter context
- Wholesale level adjustment – Converted the retail rate to a wholesale rate by a factor of about 1.5x the retail amount.
Thus, the court determined an appropriate retail royalty would be 30 percent (17+7+3.5+2.5=30) and an appropriate wholesale royalty would be 44 percent.
The adjustments outlined by the court are noteworthy because they highlight specific adjustments and applications made to a CUT method comparable observation, and taxpayers may be able to rely on these adjustments in supporting their own methodology. Taxpayers frequently use court cases to support specific adjustments in transfer pricing matters.
For example, after the court ruled that a stock option based adjustment should be considered in the Xilinx case, practitioners often performed stock option adjustment calculations, even if they were de minimis, to align their analyses with the court’s opinion. The court’s decision in the Xilinx case was later withdrawn and the stock options adjustment fell out of favor, but the adjustments in the Medtronic case may be worth considering nonetheless
The adjustments are also noteworthy because they are based on taxpayer specific facts instead of regulatory guidance that required the adjustments. Specifically, the court supports its adjustments based specific factual findings as outlined below:
- Know-how – the court makes a 7 percent adjustment because the court concludes the know-how provided in the intercompany context “is equivalent to the exclusivity”
- Profit potential – the court makes a 3.5 percent adjustment is made the court concludes “exclusivity and know-how have a greater impact on the value of the licenses” and “(f)or this reason we halve the amount”
- Scope of products – the 2.5 percent adjustment is made because the court concludes products covered in the intercompany context are broader than products covered in the Pacesetter context, so an adjustment “slightly more than one-third the Pacesetter royalty rate, is a proper adjustment.”
Because the adjustments were based on the taxpayer’s specific facts, the particular adjustments may not have significant precedential value. On the other hand taxpayers with similar facts may find the case extremely useful in applying the CUT method.