Steven Bennett v. HHS

United States Court of Appeals
For the Eighth Circuit
___________________________
No. 23-3063
___________________________
Medtronic, Inc. & Consolidated Subsidiaries,
lllllllllllllllllllllAppellee,
v.
Commissioner of Internal Revenue,
lllllllllllllllllllllAppellant.
___________________________
No. 23-3281
___________________________
Medtronic, Inc. & Consolidated Subsidiaries,
lllllllllllllllllllllAppellant,
v.
Commissioner of Internal Revenue,
lllllllllllllllllllllAppellee.
____________
Appeals from the United States Tax Court
____________
Submitted: May 13, 2025
Filed: September 3, 2025
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Before COLLOTON, Chief Judge, SMITH and SHEPHERD, Circuit Judges.
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COLLOTON, Chief Judge.
For nearly fifteen years, the Commissioner of Internal Revenue and Medtronic,
Inc. have been embroiled in litigation over the amount of income Medtronic’s 2005
and 2006 consolidated tax returns attributed to a subsidiary, Medtronic Puerto Rico.
In Medtronic, Inc. & Consolidated Subsidiaries v. Commissioner, 900 F.3d 610 (8th
Cir. 2018), this court vacated the tax court’s first decision in the case and remanded
with instructions to make additional fact findings. The findings were necessary to
facilitate review of whether the tax court applied the best method for calculating an
arm’s length price for intangible property that was transferred between two Medtronic
entities. Id. at 615.
The Commissioner now appeals the tax court’s decision on remand. He argues
that the tax court erred by rejecting his proposed transfer pricing method and by
adopting a different method that the Commissioner maintains is prohibited under the
applicable regulations. Medtronic cross-appeals and asserts that the tax court clearly
erred in rejecting the taxpayer’s proposed transfer pricing method. Alternatively,
Medtronic argues that this court should uphold the tax court’s selected transfer
pricing method, but direct certain adjustments. We vacate the tax court’s order and
remand for further proceedings consistent with this opinion.
I.
Medtronic is a medical device company that produces and markets class III
devices, which include implantable cardiac rhythm stimulation and neurostimulation
devices as well as the electrodes or “leads” that connect those devices to the human
body. Medtronic’s parent company, Medtronic US, and its distributor, Medtronic
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USA, Inc. (Med USA), are located in Minnesota. The company’s class III device
manufacturer, Medtronic Puerto Rico Operations Co. (Medtronic Puerto Rico), is
located in Puerto Rico.
Medtronic allocates the profit earned from its devices and leads between
Medtronic US, Med USA, and Medtronic Puerto Rico through intercompany
licensing agreements. This appeal concerns agreements under which Medtronic US
granted Medtronic Puerto Rico the exclusive right to use intangible property to
manufacture and sell devices and leads in exchange for Medtronic Puerto Rico’s
agreement to pay a royalty based on net sales to Medtronic US. We refer to these
agreements as the Technology Licenses.
The Internal Revenue Code empowers the Commissioner to allocate gross
income between or among commonly controlled parties “if he determines that
such . . . allocation is necessary in order to prevent evasion of taxes or clearly to
reflect the income of any such” entities. 26 U.S.C. § 482.* The taxable income
attributed to a controlled taxpayer participating in a controlled transaction is
determined as if the parties were “dealing at arm’s length.” 26 C.F.R. § 1.482-
1(b)(1). “A controlled transaction meets the arm’s length standard if the results of the
transaction are consistent with the results that would have been realized if
uncontrolled taxpayers had engaged in the same transaction under the same
circumstances . . . .” Id.
The regulations specify four methods to evaluate whether the amount charged
in a controlled transfer of intangible property meets the arm’s length standard. See
id. § 1.482-4(a). Three are relevant to this case. The comparable uncontrolled
transaction method “evaluates whether the amount charged for a controlled transfer
*All citations to the Internal Revenue Code and Treasury Regulations are to the
versions in effect during the 2005 and 2006 tax years.
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of intangible property was arm’s length by reference to the amount charged in a
comparable uncontrolled transaction.” Id. § 1.482-4(c)(1). The comparable profits
method “evaluates whether the amount charged in a controlled transaction is arm’s
length based on objective measures of profitability (profit level indicators) derived
from uncontrolled taxpayers that engage in similar business activities under similar
circumstances.” Id. § 1.482-5(a). The regulations also permit the use of “unspecified
methods” if they satisfy applicable requirements. Id. § 1.482-4(d). The transaction
must be evaluated under the “best method”—that is, “the method that, under the facts
and circumstances, provides the most reliable measure of an arm’s length result.” Id.
§§ 1.482-4(a), -1(c)(1).
As explained in Medtronic I, this case began with a dispute about Medtronic’s
2002 consolidated tax return. See 900 F.3d at 612. That return used the comparable
uncontrolled transaction method to determine the royalty rates paid on its
intercompany licensing agreements. After an audit in which the Internal Revenue
Service disputed Medtronic’s transfer pricing method and profit allocation, the IRS
and Medtronic entered into a memorandum of understanding in which Medtronic
Puerto Rico would pay wholesale royalty rates of 44% for devices and 26% for leads
on its intercompany sales. These royalty rates resulted in an overall profit split of
approximately 55.6% for Medtronic US/Med USA and 44.4% for Medtronic Puerto
Rico.
The IRS and Medtronic could not agree on how the memorandum of
understanding should apply to Medtronic Puerto Rico’s royalty payments to
Medtronic US for the 2005 and 2006 tax years. After auditing Medtronic’s
consolidated returns, the IRS determined that the comparable profits method was the
best way to determine an arm’s length price for Medtronic’s intercompany licensing
agreements for those two years, and the IRS charged Medtronic with a tax deficiency.
Medtronic disputed the adjustment and filed suit in the United States Tax Court,
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arguing that the comparable uncontrolled transaction method was the best method for
determining an arm’s length royalty rate for the intercompany licensing agreements.
After a trial, the tax court rejected both parties’ royalty rate valuations, and
conducted its own valuation analysis. The court ultimately decided that Medtronic’s
comparable uncontrolled transaction method was the best way to determine an arm’s
length royalty rate for the intercompany licensing agreements, but made a number of
adjustments. The tax court then determined arm’s length wholesale royalty rates for
intercompany sales of 44% for device licenses and 22% for leads licenses, which
resulted in an overall profit split of 54.1% to Medtronic US/Med USA and 45.9% to
Medtronic Puerto Rico. The court then issued an order concluding that Medtronic
had an income tax deficiency in 2005 and an overpayment in 2006. The
Commissioner appealed and sought a reevaluation of the best transfer pricing method
and a recalculation of the arm’s length royalty rate.
On appeal, this court held that the tax court’s factual findings were insufficient
to allow a determination whether the tax court correctly accepted a patent-licensing
agreement between Medtronic US and Siemens Pacesetter as a comparable
uncontrolled transaction, and whether the tax court “applied the best transfer pricing
method.” Medtronic I, 900 F.3d at 614-15. Accordingly, this court vacated the tax
court’s order and remanded the case for further consideration and factual findings
“necessary to our determination whether the tax court applied the best transfer pricing
method for calculating an arm’s length result or whether it made proper adjustments
under its chosen method.” Id. at 615.
On remand, Medtronic again maintained that the Pacesetter Agreement is
comparable to the Technology Licenses and that the comparable uncontrolled
transaction method is the best method to determine an arm’s length royalty. The
Commissioner argued that the comparable profits method is the best method to price
the Technology Licenses, and proposed a modified version of that method which
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relied on a set of five comparable companies, narrowed from a set of fourteen offered
at the first trial. Medtronic also proposed, in the alternative, a three-step unspecified
method that incorporated aspects of the parties’ comparable uncontrolled transaction
method and comparable profits method and then allocated residual profits between
Medtronic US and Medtronic Puerto Rico.
After another trial, the tax court abandoned its previous conclusion that a
Pacesetter Agreement-based application of the comparable uncontrolled transaction
method was the best method to determine an arm’s length royalty rate for the
Technology Licenses. The court found that three of the five general comparability
factors described in § 1.482-1(d)(1) were not satisfied. First, the court determined
that Medtronic Puerto Rico and Pacesetter “did not perform the same functions.” See
id. § 1.482-1(d)(1)(i), (3)(i). Second, the court found that the economic conditions
between the agreements were not comparable because the property involved in the
two agreements did not have similar profit potential. See id. §§ 1.482-1(d)(1)(iv), -
4(c)(2)(iii)(B)(1)(ii). And third, the court concluded that the property licensed under
the agreements was not similar: the Pacesetter Agreement licensed only patents,
while the Technology Licenses encompassed the “full array of intangible property”
needed to manufacture devices and leads for sale, including patents, know-how,
regulatory approvals, secret processes, technical information and expertise, and
copyrights. See id. § 1.482-1(d)(1)(v), (3)(v).
The tax court next determined that the Commissioner’s modified comparable
profits method could not be the best method to price the Technology Licenses. The
court reasoned that the Commissioner erroneously relied on companies that made
different products and carried different asset bases, functions, and risks than
Medtronic Puerto Rico. The tax court also rejected the Commissioner’s proposed
adjustment to account for differences in the product liability risk borne by Medtronic
Puerto Rico compared to the proposed comparable companies. See id. §§ 1.482-
5(c)(2)(iv), -1(d)(2).
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Having rejected the preferred methods of both parties, the tax court applied
Medtronic’s three-step unspecified method, with some adjustments. Step one applied
a modified version of Medtronic’s Pacesetter Agreement-based comparable
uncontrolled transaction method as a “starting point” to price Medtronic US’s
research and development activities. Step two applied a modified version of the
Commissioner’s comparable profits method to allocate profit to Medtronic Puerto
Rico’s finished-device manufacturing functions. Step three split the remaining profit
from the devices and leads between Medtronic US and Medtronic Puerto Rico. The
tax court determined a wholesale royalty rate of 48.8% for both leads and devices,
which resulted in an overall profit split of 68.7% to Medtronic US/Med USA and
31.3% to Medtronic Puerto Rico. The court then issued an order concluding that
Medtronic had income tax deficiencies in 2005 and 2006.
The Commissioner appeals the tax court’s order, asserting several legal errors
in the decision to adopt the three-step unspecified method and reject his proposed
comparable profits method. Medtronic cross-appeals and argues that the tax court
clearly erred in finding that the Pacesetter Agreement is not a comparable
uncontrolled transaction. Alternatively, the taxpayer contends that we should uphold
the tax court’s unspecified method but remand for reconsideration of its adjustments
at step three. We review the tax court’s legal conclusions de novo and factual
findings for clear error. Medtronic I, 900 F.3d at 613.
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II.
A.
Medtronic first challenges the tax court’s rejection of the Pacesetter Agreement
as a comparable uncontrolled transaction. The taxpayer argues that an application of
the comparable uncontrolled transaction method based on the Pacesetter Agreement
is the best method for pricing the Technology Licenses. That method “evaluates
whether the amount charged for a controlled transfer of intangible property was arm’s
length by reference to the amount charged in a comparable uncontrolled transaction.”
26 C.F.R. § 1.482-4(c)(1).
In the absence of an uncontrolled transaction involving the same intangible
property, application of the comparable uncontrolled transaction method “requires
that the controlled and uncontrolled transactions involve . . . comparable intangible
property,” and that the transactions arise “under comparable circumstances.” Id.
§ 1.482-4(c)(2)(iii)(A), (ii). To be “comparable” in the relevant sense, the intangible
property involved in an uncontrolled transaction “must . . . [h]ave similar profit
potential” to the intangible property involved in the controlled transaction. Id.
§ 1.482-4(c)(2)(iii)(B)(1)(ii).
The tax court found that the intangible property licensed under the Pacesetter
Agreement and the Technology Licenses do not have similar profit potential. The
court cited, inter alia, a report by the Commissioner’s expert Michael Heimert
showing that Pacesetter’s product profit margin from intellectual property licensed
under the Pacesetter Agreement averaged 29% from 1993 to 1995, compared to
Medtronic’s 54% average product profit margin in 2005 to 2006 from intellectual
property licensed under the Technology Licenses.
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Medtronic challenges the tax court’s finding on profit potential. The taxpayer
first argues that the tax court failed to consider the effect of a clause in the Pacesetter
Agreement that permitted either Pacesetter or Medtronic US to license any of the
other party’s relevant patents developed during the term of the agreement for an
aggregate rate of no more than 15%, with an exception for certain “key patents.”
Medtronic asserts that this maximum rate clause “accounts for any difference in [the]
profit potential” of the property licensed under the Pacesetter Agreement compared
to the profit potential of the property licensed under the Technology Licenses. But
this provision applied exclusively to licenses for patents—the only intangible
property transferred under the Pacesetter Agreement. In contrast, Medtronic Puerto
Rico obtained the right to exploit “the full array of intangible property” necessary to
manufacture and sell devices and leads, including “patents, trade secrets, know-how,
copyrights, and all regulatory approvals associated with” the products.
Medtronic’s reliance on the 15% maximum rate clause is premised on its
contention that the “core value” of the Technology Licenses is derived from the same
patent rights that Medtronic US licensed to Siemens Pacesetter. The taxpayer further
asserts that the benefits Medtronic Puerto Rico obtained from the non-patent
intellectual property licensed under the Technology Licenses—particularly know-
how and regulatory approvals—were small compared to the patents, and should be
disregarded in the comparability analysis.
The tax court found, however, that the know-how and regulatory approvals
were valuable, and this finding is supported by the record. The Commissioner’s
expert Heimert attributed the difference in profit margins to the difference in the
intangible property involved in each transaction. He opined that “[t]he broader range
of IP subject to the [Medtronic Puerto Rico] License conveys significantly more value
than the bare patent license conveys to Siemens [Pacesetter].” “Because IP with
higher profit potential should, all else equal, attract higher royalty rates,” Heimert
explained, “the IP licensed under the [Medtronic Puerto Rico] License would attract
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a much higher royalty rate than the IP licensed under the Pacesetter [Agreement].”
See id. § 1.482-4(c)(2)(iii)(B)(1)(ii) (“The profit potential of an intangible is most
reliably measured by directly calculating the net present value of the benefits to be
realized (based on prospective profits to be realized or costs saved) through the use
or subsequent transfer of the intangible . . . .”). Because the non-patent intellectual
property licensed under the Technology Licenses conveyed additional profit potential,
the 15% maximum royalty rate on patents stipulated in the Pacesetter Agreement does
not account for differences in the profit potential of the property licensed under the
Pacesetter Agreement and the Technology Licenses.
Medtronic also asserts that differences in the profit potential between property
involved in uncontrolled and controlled transactions does not preclude comparability
“[i]f the difference can (as here) be accounted for” by making certain adjustments.
Medtronic cites the general comparability standard described in § 1.482-1(d). That
standard provides that even when there are “material differences” between controlled
and uncontrolled transactions, “adjustments must be made if the effect of such
differences on prices or profits can be ascertained with sufficient accuracy to improve
the reliability of the results.” Id. § 1.482-1(d)(2). The regulations specific to
transfers of intangible property, however, permit adjustments to account for
differences in circumstances of controlled and uncontrolled transactions, not for
differences in the intangible property transferred, which “must . . . [h]ave similar
profit potential.” Id. §§ 1.482-4(c)(2)(iii)(A), (B)(1)(ii) (emphasis added).
We conclude that the tax court did not clearly err by finding that the Pacesetter
Agreement and the Technology Licenses did not transfer comparable intangible
property, and that the Pacesetter Agreement cannot be used as a comparable
uncontrolled transaction to determine an arm’s length royalty rate for the Technology
Licenses. See id. § 1.482-4(c)(2)(iii)(B)(1)(ii). The comparable uncontrolled
transaction method is therefore not the best method to determine an arm’s length
royalty rate for the Technology Licenses.
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III.
The Commissioner challenges the tax court’s three-step unspecified method,
which uses the Pacesetter Agreement as a “starting point” for the analysis. The
regulations permit the use of “methods not specified” in § 1.482-4(a)(1)-(3)—i.e., the
comparable uncontrolled transaction method, the comparable profits method, and the
profit split method—to evaluate whether the amount charged in a controlled transfer
of intangible property is arm’s length. Id. § 1.482-4(d)(1). The Commissioner argues
that because the Pacesetter Agreement fails the similar-profit-potential requirement
of the comparable uncontrolled transaction method, see § 1.482-4(c)(2)(iii)(B)(1)(ii),
the tax court may not use the agreement to determine an arm’s length price for a
controlled transaction under an unspecified method.
We find merit in the Commissioner’s position. Section 1.482-4(d)(1) instructs
that “[c]onsistent with the specified methods, an unspecified method should take into
account the general principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to the transaction, and only enter
into a particular transaction if none of the alternatives is preferable to it.” Id. “[A]n
unspecified method should provide information on the prices or profits that the
controlled taxpayer could have realized by choosing a realistic alternative to the
controlled transaction.” Id. “[T]he reliability of a method will be affected by the
reliability of the data and assumptions used to apply the method.” Id. The purpose
of the regulations is thus to identify a realistic alternative to the controlled transaction
at issue, and to determine a price for the controlled transaction based on what the
controlled taxpayer could have realized if it had undertaken the realistic alternative.
Section 1.482-4(a) lists three examples of methods used to find a realistic
alternative to a controlled transfer of intangible property. The provisions that follow
explain when data weighed in the application of each of those methods are reliable.
The comparable uncontrolled transaction method “compares a controlled transaction
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to similar uncontrolled transactions to provide a direct estimate of the price the parties
would have agreed to had they resorted directly to a market alternative to the
controlled transaction.” Id. § 1.482-4(d)(1). Section 1.482-4(c)(2)(iii)(B)(1)(ii)
specifies that an uncontrolled transaction constitutes reliable data with which to
evaluate a controlled transaction—i.e., it is a realistic alternative to which the
controlled taxpayer could have resorted directly in the free market—only if the
property involved in the uncontrolled transaction has “similar profit potential” to the
property involved in the controlled transaction.
As applied to this case, the tax court found that the property transferred under
the Pacesetter Agreement and the property transferred under the Technology Licenses
do not have similar profit potential. The Pacesetter Agreement therefore does not
provide reliable data to use in evaluating whether the amount charged in a controlled
transaction is consistent with the amount to which the parties would have agreed in
a transaction taking place at arm’s length. See id. § 1.482-4(d)(1). We therefore
reject the tax court’s use of the Pacesetter Agreement under an unspecified method
to determine an arm’s length price for the Technology Licenses.
IV.
The Commissioner next challenges the tax court’s rejection of his proposed
application of the comparable profits method. This method evaluates whether the
amount charged in a controlled transaction is arm’s length by comparing the amount
of operating profit that one party to the transaction (the “tested party,” here Medtronic
Puerto Rico) would have earned “if its profit level indicator were equal to that of an
uncontrolled comparable (comparable operating profit).” Id. § 1.482-5(b)(1). “Profit
level indicators are ratios that measure relationships between profits and costs
incurred or resources employed.” Id. § 1.482-5(b)(4). An “uncontrolled comparable”
is an unrelated taxpayer that engages in similar business activities under similar
circumstances. Id. § 1.482-5(a).
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Under the comparable profits method, a profit level indicator is selected and
applied to the financial information of comparable parties to determine their
profitability. Id. § 1.482-5(b)(1), (4). After application of the profit level indicator,
“[t]he tested party’s reported operating profit is compared to the comparable
operating profits derived from the profit level indicators of uncontrolled comparables
to determine whether the reported operating profit represents an arm’s length result.”
Id. § 1.482-5(b)(1). The comparable profits method “relies on the general principle
that similarly situated taxpayers will tend to earn similar returns.” Intercompany
Transfer Pricing Reguls. Under Section 482, 59 Fed. Reg. 34971, 34985 (July 8,
1994).
A.
The Commissioner first contends that the tax court erred in rejecting the
comparable profits method on the ground that his proposed comparable companies
“did not make solely class III medical devices,” but also made class I and class II
medical devices. The tax court also noted that Medtronic Puerto Rico manufactured
cardiological and neurological devices, while the proposed comparable companies
made orthopedic, vascular, and urology products.
We conclude that the tax court applied an incorrect standard in rejecting the
comparable profits method. Under that method, “[t]he degree of comparability
between an uncontrolled taxpayer and the tested party is determined by applying the
provisions of § 1.482-1(d)(2).” 26 C.F.R. § 1.482-5(c)(2)(i). The general
comparability standard of § 1.482-1(d)(2) does not require that proposed comparable
companies produce the same products as the tested party, but requires only that the
comparable companies are “sufficiently similar” to the tested party to provide “a
reliable measure of an arm’s length result.” Id. § 1.482-1(d)(2). The regulations
emphasize that the general comparability provisions described in § 1.482-1(d) should
be tailored to the specific transfer pricing method under consideration. Id. § 1.482-
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1(d)(1). “[T]he comparable profits method is not as dependent on product similarity”
as are other methods, “[b]ecause operating profit usually is less sensitive than gross
profit to product differences.” Id. § 1.482-5(c)(2)(iii); see also id. § 1.482-8, Ex. 6
(comparable profits method is best method despite “significant differences” between
the products manufactured).
In rejecting the Commissioner’s proposed comparable companies because they
“did not make solely class III medical devices,” the tax court overemphasized the
importance of product similarity under the comparable profits method. On remand,
the tax court should apply the correct legal standard, and consider whether the
proposed comparable companies were “sufficiently similar” to Medtronic Puerto Rico
and, if not, whether adjustments can be made to account reliably for any material
differences. See id. §§ 1.482-1(d)(2), -5(c)(2)(iv).
B.
The Commissioner next disputes the tax court’s conclusion that his proposed
comparable companies “have fundamentally different asset bases and involve
different functions and risks” than Medtronic Puerto Rico. See id. § 1.482-5(c)(2)(ii)
(identifying resources employed, risks assumed, and functions performed as
particularly important considerations in determining the degree of comparability
between the tested party and an uncontrolled taxpayer). The tax court did not make
sufficient factual findings to support this conclusion.
i.
The Commissioner proposed the “return-on-assets” profit level indicator to
determine the profitability of the comparable parties. See id. § 1.482-5(b)(1), (4)(i).
This indicator measures a company’s profit level by comparing its operating profit
to its operating assets. Id. § 1.482-5(b)(4)(i). The Commissioner cited two reasons
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for his proposed indicator: (1) this profit level indicator is most reliable when a
company’s operating assets play a critical role in its ability to generate operating
profits, and (2) the level of functional comparability required between the controlled
and uncontrolled transactions is reduced when using the return-on-assets profit level
indicator as compared to ratios that measure relationships between profit and costs
or revenue. See id. § 1.482-5(b)(4)(i), (ii).
In rejecting the Commissioner’s proposed comparable companies on the basis
of their “fundamentally different asset bases,” the tax court made no findings
regarding what those differences were, what effect the differences had on the amount
of profit allocated to Medtronic Puerto Rico, or whether adjustments could be made
to account reliably for any material differences that negatively impacted Medtronic
Puerto Rico’s profit allocation. See id. § 1.482-5(c)(2)(iv). Medtronic contests this
point on the view that the tax court rejected altogether the use of the return-on-assets
profit level indicator. That is not our understanding of the tax court’s decision.
Although the tax court in 2017 cast doubt on use of the return-on-assets profit level
indicator, the court did not do so on remand in 2022. In fact, the tax court employed
the return-on-assets profit level indicator as part of its three-step unspecified method.
Medtronic also contends that the tax court found that Medtronic Puerto Rico
“had specialized, valuable intangible assets related to its expertise in manufacturing
class III medical devices, while the proposed comparables did not.” That assertion
is not supported by the record. Although the tax court found that Medtronic Puerto
Rico had a “highly skilled workforce,” the court made no finding that the
Commissioner’s five proposed comparable companies did not. The tax court found
that Medtronic Puerto Rico and the Commissioner’s proposed comparable companies
had “fundamentally different asset bases,” with no further explanation.
On remand, the tax court should make findings as to what were the purported
differences in asset bases, what effect any differences had on the amount of profit
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allocated to Medtronic Puerto Rico, and, if necessary, whether adjustments can be
made to account reliably for any material differences that negatively impacted
Medtronic Puerto Rico’s profit allocation.
ii.
The Commissioner next challenges the tax court’s rejection of the comparable
profits method on the basis that Medtronic Puerto Rico and the proposed comparable
companies perform “different functions.” The Commissioner acknowledges that
Medtronic Puerto Rico performed only one function—finished-product
manufacturing—while the proposed comparable companies all performed additional
functions, including research and development and distribution. But, he argues, the
comparable companies’ performance of additional functions does not render the
comparable profits method unreliable.
We conclude that performance of different functions by proffered comparable
companies is insufficient reason to reject the comparable profits method. The
comparable profits method accounts for functional differences between the tested
party and comparable companies because “differences in functions performed often
are reflected in operating expenses,” so that companies “performing different
functions may have very different gross profit margins but earn similar levels of
operating profits.” Id. § 1.482-5(c)(2)(ii). Indeed, the comparable profits method
may be used to price intangible property even where significant functional differences
“are likely to materially affect gross profit margins, but it is not possible to identify
the specific differences and reliably adjust for their effect on gross profit.” Id.
§ 1.482-8, Ex. 6. That the Commissioner’s proposed comparable companies perform
functions other than finished-product manufacturing does not render the comparable
profits method inapplicable.
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Accordingly, on remand the tax court should reconsider the comparability of
the functions performed by Medtronic Puerto Rico and the Commissioner’s five
proposed comparable companies, and apply the approach to functional differences
envisioned by the regulations. See id. §§ 1.482-5(c)(2)(ii), -8, Ex. 6.
We also conclude that the court did not make sufficiently specific findings
regarding the amount of product liability risk borne by Medtronic Puerto Rico during
tax years 2005 and 2006. See id. §§ 1.482-5(c)(2)(ii), -1(d)(3)(iii)(A)(5). The court
noted the parties’ contrasting evidence about the amount of risk borne by Medtronic
Puerto Rico during those years: the Commissioner’s expert quantified the
subsidiary’s risk at around $25 million, and Medtronic’s expert placed the amount at
$220 million to $235 million. The tax court also observed that Medtronic Puerto
Rico had incurred product liability costs ranging from $117 million to $324 million
in four previous recalls of devices and leads. The tax court, however, did not resolve
the factual dispute about quantity of risk. The tax court instead rejected the
Commissioner’s $25 million valuation and corresponding adjustment as “not in line
with the costs associated with prior recalls,” and found simply that “all the product
liability risk was allocated to, and borne by” Medtronic Puerto Rico. Without a
finding on the amount of product liability risk borne by Medtronic Puerto Rico in tax
years 2005 and 2006, we cannot properly evaluate the tax court’s rejection of the
Commissioner’s proposed comparable profits method. See Medtronic I, 900 F.3d at
615.
Nor did the tax court make sufficient findings to support its implicit conclusion
that any difference in risks borne by the proposed comparable companies and those
borne by Medtronic Puerto Rico was material. Although the tax court credited
testimony from Medtronic’s expert Glenn Hubbard that “quality is more important for
a manufacturer solely of class III devices than for the companies [the Commissioner’s
expert] Heimert selected as comparables,” the findings do not explain why the
manufacturer of class III devices necessarily bears more financial risk than a company
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that manufactures class I, II, and III devices. On remand, the tax court should
quantify the amount of product liability risk borne by Medtronic Puerto Rico and the
Commissioner’s proposed comparable companies, evaluate whether any difference
between them is material with respect to the comparability of profits earned, and, if
necessary, consider whether an adjustment can be made to account reliably for any
material difference. See 26 C.F.R. § 1.482-5(c)(2)(iv).
C.
After making these findings, the tax court should reconsider its conclusion that
the Commissioner’s allocation of 12-14% of the profit from the devices and leads to
Medtronic Puerto Rico was “unreasonable.” The tax court reached that conclusion
“for the same reasons” given in its 2017 opinion after observing that “the five
comparables are not identified as solely class III products.” The court should reassess
its conclusion after reevaluating the comparable companies under the comparable
profits method as discussed above.
V.
In addition to the comparable profits method, the Commissioner offered
evidence that Medtronic could replace Medtronic Puerto Rico in its function as a
finished-device manufacturer by relying on a different Medtronic facility or building
a new manufacturing facility. See id. §§ 1.482-4(d)(2) (royalty paid by foreign
subsidiary to U.S. parent to license a proprietary widget production process is not
arm’s length if the U.S. parent could have earned more profit by producing the widget
itself), -1(d)(3)(iv)(H) (comparability of economic conditions analysis requires
considering the “alternatives realistically available to the buyer and seller”). The tax
court acknowledged this point, saying that “there is a possibility that [Medtronic
Puerto Rico] could have been replicated,” albeit “not without substantial time and
cost.” The tax court, however, made no findings about how much time and cost
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Medtronic would have to incur to replicate Medtronic Puerto Rico’s role in the
conglomerate’s structure. On remand, the tax court should make those findings and
determine whether manufacturing the devices and leads in a different Medtronic
facility or building a new manufacturing facility was a realistic alternative to the
Technology Licenses. This determination is necessary to facilitate review of the tax
court’s ultimate profit allocation to Medtronic Puerto Rico.
* * *
For these reasons, we vacate the tax court’s order and remand the case for
further proceedings consistent with this opinion.
______________________________
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