On August 16, 2018, in the case of Medtronic vs. Commissioner, the Eighth Circuit Court vacated an earlier Tax Court’s decision and remanded the case to be re-examined in light that the lower court “erred in not applying the correct transfer pricing method when calculating the arm’s length royalty rates for Medtronic’s intercompany licenses.”[1]  Through remanding, the Circuit Court was not rejecting any analysis offered per se, but rather is ordering the Tax Court to reexamine the case in light of its earlier support of the Comparable Uncontrolled Transaction (“CUT”) method without justifying its selection as the best method as required under the §482 Regulations.

The case involves Medtronic’s 2005 and 2006 taxation years.  The taxpayer had selected the CUT methodology (based on an external comparable) while the IRS used the Comparable profits Method (“CPM”) in their analysis.  In the Tax Court’s decision, they rejected both taxpayer and the IRS positions but agreed with the taxpayer that the CUT was the best method.  However, the tax court, in their decision, proceeded to make various adjustments to the CUT such that the proposed royalty was adjusted from the taxpayer’s proposed 7% to 44% for device licenses and 22% for lead licenses.[2]

The Eight Circuit Court rejected the above based on the following arguments:

  • The tax court did not address in sufficient detail whether the circumstances of the settlement in the uncontrolled transaction were comparable with controlled licensing agreement;
  • The tax court did not analyze the degree of comparability of the third-party transaction with the related party transaction;
  • The tax court also did not evaluate how the different treatment of intangibles between agreements impacted comparability (for example, one included “know-how” while the other did not);
  • The tax court did not properly consider the allocation of risk and product liability expenses to be split between the Medtronic related parties.[3]

Although remanding the case back to the district tax court does not necessarily mean the court’s decision will ultimately change, it does address the importance of certain matters when assessing what the best method is when performing a US transfer pricing analysis.  In short, comparability between the controlled and uncontrolled transactions must be considered before any determination of what the best method to apply is in a certain case.  If multiple adjustments are required to obtain a comparability, then considerations must be given that the CUT methodology is not the best method and that other approaches should be considered.  Ultimately, the Eight Circuit Court felt that this comparability analysis had not been performed to a sufficient level when assessing the best method.

The ruling will require the tax court to once again reconsider the case and perform this comparability analysis.  Two outcomes are likely: i) the CUT methodology is upheld (but justified) as the best method, or ii) the court finds that through their comparability analysis, another methodology would be preferred under the circumstances.  The outcome of this comparability analysis may also ultimately change the final answer rendered by the court as to an arm’s length royalty rate.  Given that over $1.3 billion in adjustments were proposed by the IRS, both parties will likely be anxiously awaiting a newly rendered decision.

The takeaway for all taxpayers with US operations (whether they are using the CUT or another methodology) is that their documentation should include a sufficient justification of selecting the best method under the circumstances. Too often, taxpayers may by default select the CUT or CPM methodologies without sufficiently considering all the necessarily factors (and documenting this process).  This case also illustrates the wide disparity in results that can be rendered by the use of different methodologies.  Thus, rushing an analysis to only end up selecting the wrong methodology may result in material differences when disputes with tax authorities arise.

For Canadian taxpayers, there are still some takeaways as well.  The Canadian rules promote a “natural hierarchy” approach rather than the best method, thus forcing taxpayers to first consider CUPs/CUTs before moving on to consider other methodologies.  Royalties and licenses are often complicated transactions, thus due consideration must be given to the potential differences both in circumstances and contractually between the controlled and uncontrolled transactions.  The more adjustments required in an analysis, the less likely those transactions are comparable.  Forcing an answer by making an “inexact CUT” argument may not necessarily render an arm’s length result or something that is supportable under scrutiny.

[1] United States Court of Appeals for the Eighth Circuit, No. 17-1866, Medtronic Inc & Consolidated Subsidiaries vs. Commissioner of Internal Revenue, Filed: August 16 2018, page 2.

[2] Ibid. pgs. 4-5

[3] Ibid., pgs. 7-8