United States

IRS appeals Tax Court decision in Medtronic

IRS requests case be remanded for further consideration

INSIGHT ARTICLE  | 

In an appellate brief filed for the U.S. Court of Appeals for the Eighth Circuit filed July 21, the Internal Revenue Service (IRS) asserts the Tax Court erred in its opinion in the transfer pricing case, Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue.  Enumerating numerous concerns with the court’s rationale and conclusions, the Commissioner requests that the court’s decision be reversed and the case be remanded.  As with the court opinion in Medtronic, the Commissioner’s appeal provides insight for taxpayers interested in transfer pricing.

Background

At issue in Medtronic is whether the profit resulting from intercompany transactions between Medtronic’s U.S. entities and Puerto Rican affiliate were consistent with U.S. regulations.  The IRS argued the comparable profits method (CPM) was the best transfer pricing method for analyzing the results of the intercompany transactions while Medtronic argued the comparable uncontrolled transaction (CUT) method was the best method.  In the tax court opinion, Judge Kathleen Kerrigan applied the CUT method, albeit a modified version of Medtronic’s approach, with numerous adjustments made to a single comparable uncontrolled transaction (the Pacesetter agreement).

IRS appeal

In its appellate brief, the IRS concludes the Tax Court erred as a matter of law in its adoption of the CUT method and failed to apply regulatory standards.  The IRS outlines numerous concerns with the court’s approach which are summarized below.

  • Litigation – The single transaction upon which the court relied was a litigation settlement. Generally, transactions occurring in the normal course of business are sought as comparable transactions and litigation is outside the normal course of business.  Hence the Pacesetter agreement could be rejected.
  • Lump sum – The single transaction upon which the court relied included a lump sum payment. Lump sum payments can affect the compensation structure of CUT method comparable observations, and the Commissioner indicates this was not considered in the Medtronic decision. Hence the results of the Pacesetter agreement should be adjusted.
  • Cross license – The single transaction upon which the court relied was a cross license. Cross license agreements are often rejected as comparable uncontrolled transactions because they involve licenses between both parties, rather than a license solely between a licensor and a licensee.  Hence the Pacesetter agreement could be rejected.
  • Different intangibles – The Commissioner argues the intangibles in the single CUT method transaction used by the court are not comparable to the intangibles at issue in Medtronic.  Further, the Commissioner indicates the court’s findings themselves demonstrate the differences.  Hence the Pacesetter agreement could be rejected.
  • Different functions – The Commissioner argues the functions of the entities in the single CUT method transaction are not adequately compared to the functions of the entities in Medtronic.  The IRS posits functional comparability should be explored in a CUT method analysis consistent with U.S. regulations.  Hence the Pacesetter agreement could be rejected and, at least, the results of the Pacesetter agreement should be adjusted.
  • Profit potential – The regulations maintain comparable observations should be adjusted if their potential profit differs from that of the controlled transaction. The Commissioner disagrees with the court’s application of a profit potential adjustment to the Pacesetter agreement in Medtronic, calling it “an arbitrary adjustment.”  Hence the results of the Pacesetter agreement should be adjusted.
  • Too many adjustments – The regulations indicate adjustments can be made to comparable observations to increase their comparability, however, if too many adjustments are required, it undermines the comparability of the observations themselves.  The IRS indicates the number of adjustments made to the single observation in Medtronic undermines the comparability of the observation itself and the Pacesetter agreement could be rejected.

Although the appellate brief details these multiple issues, the IRS concludes it does “not mean to blur the forest by detailing the trees.”  In transfer pricing, the Commissioner asserts, the reasonableness of the result is more important than the details of the methodology employed.  Ultimately, the appellate brief concludes, the results of the court’s opinion in Medtronic are not reasonable.

Consequently, the IRS indicates the Tax Court’s decision should be reversed and the case should be remanded with instructions that the transfer pricing method employed be revisited.  Further, the brief argues the Commissioner’s CPM approach should be employed as the best method.  Absent the adoption the CPM approach, the brief argues the CUT method should be revised with additional adjustments being made.

Whether the Eighth Circuit considers the appeal remains to be seen.  However, taxpayers should note the approach enumerated by the IRS in its briefing.  As may be the case with the court’s initial decision in Medtronic, the appeal could affect future transfer pricing outcomes. 

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