On June 9, 2016, the United States Tax Court issued an opinion rejecting the Internal Revenue Service’s (IRS) proposed transfer pricing method that would have increased royalties payable to Medtronic, Inc. by $1.4 billion, calling the IRS’ proposed method arbitrary, capricious and unreasonable. The court instead accepted Medtronic’s chosen transfer pricing method with minor alterations.
Medtronic’s Puerto Rican affiliate, Medtronic Puerto Rico Operations Co. (MPROC), and Medtronic entered into four separate intercompany agreements covering Medtronic’s sales of components to MPROC and MPROC’s sale of finished products to Medtronic. Medtronic priced each of the four agreements separately, such that MPROC was treated as “a full-fledged entrepreneurial licensee responsible for its own success.” Despite these agreements, the IRS treated MPROC as a contract manufacturer, rather than an autonomous manufacturing licensee of medical devices.
The IRS argued that MPROC posted “outsize profits” in tax years 2005 and 2006, leading to “absurd results,” such as returns on assets of 211 percent and 301 percent, thereby making MPROC vastly more profitable than Medtronic and Medtronic’s competitors. The court found, however, that the IRS’ treatment of MPROC was fatally flawed in that it treated MPROC as a mere assembly operation, rather than a company critical to the quality of the products. The court cited several factors as indicative of the character of MPROC, including the facilities being registered with the United States Food and Drug Administration responsible for manufacturing medical devices for treatment of cardiac and neurological conditions and employing 2,300 workers—including engineers—in three locations.
While similar cases will be highly fact-specific, this case is instructive of the structure and circumstances necessary to uphold intercompany transfer pricing agreements.
Medtronic, Inc. v. Commissioner, T.C., No. 6944-11, T.C. Memo. 2016-112, June 9, 2016.