IRS’s Adjustments Were Unreasonable; Arm’s-Length Royalty Rates Same as MOU (Medtronic, Inc., TCM)

A taxpayer’s comparable uncontrolled transactions (CUT) method was the best method for determining the arm’s-length royalty rate to be paid by a Puerto Rican subsidiary to its U.S. parent. With various adjustments, made to reflect the facts and expert testimony, the rates determined were close to those previously negotiated by the parties, which were memorialized in a memorandum of understanding (MOU).

Comment. During the tax years at issue, the parent miscalculated the royalties owed by the subsidiary by using an incorrect amount for intercompany sales of medical devices and leads. The resolution of the medical and leads transfer pricing issue should determine the correct amount of royalty income that the parent should recognize on the transactions at issue.

Contrary to the taxpayer’s contention, the MOU rates on the intercompany sales of devices and leads from subsidiary to parent were not greater than arm’s length. The MOU royalty rate was 44 percent for devices and 26 percent for leads to be paid by the subsidiary on its intercompany sales and after adjustments the proper rate remained 44 percent on devices and was reduced to 22 percent on leads.

The IRS’s allocations were rejected because they were arbitrary, capricious and unreasonable. Contrary to the government’s argument the comparable profits method (CPM) was not the best method for determining the arm’s length rate. The government did not adequately consider that product quality determined the success the implantable medical device industry and that the subsidiary was ultimately responsible as the FDA-approved manufacturer of class II finished medical devices. Moreover, the licenses included specific wording that addressed quality. The subsidiary was an integral part of the group; it not only made the finished product, it made sure that the finished product was safe and could be implanted in the human body. If the subsidiary was not meeting high quality standards, it would not matter that the rest of the group was.

The issue of whether the government properly increased the amounts owed by its Swiss subsidiary to the parent under a supply agreement was resolved using the 44 percent royalty rate for medical devices.

Finally, no intangibles subject to Code Sec. 367(d) were transferred between the parent and its Puerto Rican subsidiary. Before the group was restructured, the Puerto Rican subsidiary had access to U.S. intangibles for the purpose of manufacturing and selling the parent’s medical devices. After the restructuring, the Puerto Rican subsidiary and the parent entered into the licenses, which provided the subsidiary with access to intangible property necessary to manufacture and sell devices and leads. The IRS conceded that Code Sec. 367(d) did not apply to the IP licensed by the subsidiary. Moreover, the IRS did not find that any intangibles were transferred, did not specifically identify any intangibles or explain the specific value of any intangibles that should be covered by Code Sec. 367(d) or what an appropriate arm’s-length charge would be for the use of the intangibles. Therefore, no intangibles were transferred.

Medtronic, Inc. and Consolidated Subsidiaries, TC Memo. 2016-112, Dec. 60,627(M)

Other References:

Code Sec. 367

CCH Reference – 2016FED ¶16,667.28

Code Sec. 482

CCH Reference – 2016FED ¶22,283.107

CCH Reference – 2016FED ¶22,283.28

CCH Reference – 2016FED ¶22,283.44

CCH Reference – 2016FED ¶22,283.60

Code Sec. 936

CCH Reference – 2016FED ¶28,394.40

Tax Research Consultant

CCH Reference – TRC INTL: 27,300

CCH Reference – TRC INTL: 30,114



All stories by: CCHTaxGroup

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