1. Technical meeting TPA Global 07 November, 2018 1
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2. Agenda TP Overview Medtronic business Origin of MPROC Puerto Rico
License agreement
Swiss Supply Agreement
Audits and Notice of Determination
Facts under dispute
Medtronic arguments
Tax authority arguments
Tax court decision
Court of appeal 2
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3. Overview Medtronic businessTP
Overview Medtronic business
Medical technology company.
Medical device industry was highly competitive for the years under analysis. Success depended on several factors such as product innovation, sales proficiency and service, and product quality. Truly innovative products could significantly change a company’s market share.
Business units: For this case only Cardiac Rhythm Disease Management (CDRM) and Neurological (Neuro) business units.
Class III Medical Devices and leads were at the core of the dispute.
Class III medical devices must typically be approved by FDA before they are marketed through the Premarket approval (“PMA”) process.
Class III medical devices are higher risk and more novel than are those of classes I and II 3
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4. Origin of MPROCC Puerto RicoTP
Origin of MPROCC Puerto Rico
MPROC was incorporated on August 16, 2001, under the laws of the Cayman Islands and is duly authorized to do business in Puerto Rico. MPROC was responsible for, among other things, manufacturing and selling devices (device operations) and leads (leads operations). MPROC manufactured class II and class III medical devices, as defined and determined by the FDA. MPROC also had a sales branch, known as the Puerto Rico Sales Office, located in San Juan, Puerto Rico, which sold devices and leads in Central America, South America, Puerto Rico, and the Caribbean.
MPROC filed for, and received, a grant of industrial tax exemption from the Office of Industrial Tax Exemption of the Secretary of State of Puerto Rico (grant). The grant, as amended, provided that income from “pioneer products” was not subject to Puerto Rico income taxes; dividends from such income were not subject to income and withholding taxes if MPROC met the conditions in the amended grant; and all income from other products was subject to an income tax at a rate of 2%-7% depending on employment numbers. 4
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5. TP
License agreement
MPROC Puerto Rico and Medtronic US
Medtronic US and MPROC entered into license agreements, effective as of September 30, 2001, for the intangible property used in manufacturing devices and leads.
Under the devices and leads licenses, MPROC obtained the exclusive right to use, develop, and enjoy the intangible property used in manufacturing devices for sale to customers in the United States and its territories and possessions, and leads for sale to customers worldwide.
MPROC agreed to pay an royalty of 29% to Medtronic US on its U.S. net intercompany sales of devices and 15% to Medtronic US on its net intercompany sales of leads.
On May 22, 2007, Medtronic US and MPROC entered into amended license agreements effective May 1, 2005.
The amended agreements included a profit split methodology that changed the royalty rates. MPROC would pay a 44% royalty rate to Medtronic US on its net intercompany sales of devices and a 26% royalty to Medtronic US on its net intercompany sales of leads. 5
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6. Swiss Supply AgreementTP
Swiss Supply Agreement
MPROC Puerto Rico, Medtronic US and Medtronic Europe (2005, 2006)
Under the Swiss supply agreement Medtronic Europe agreed to use its manufacturing operations in Tolochenaz, Switzerland, to assist MPROC by manufacturing and supplying the United States with devices when necessary to meet excess demand in the United States.
The Swiss supply agreement provided that Medtronic Europe would pay Medtronic US directly an amount equal to the royalty that MPROC would have paid to Medtronic US if MPROC had manufactured the product and had made the sale itself.
Medtronic Europe also agreed to pay Medtronic US directly an amount equal to the MPROC trademark royalty that MPROC would have paid to Medtronic US if MPROC had made the sale itself. 6
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7. Audits and Notice of DeterminationTP
Audits and Notice of Determination
In an audit of 2002 tax return, tax authority analysed the devices and leads intercompany transactions and the transfer prices among MPROC, Medtronic US, and Med USA, as well as the 2002 restructuring of Medtronic’s operations in Puerto Rico. At the conclusion of the examination, respondent accepted the comparable uncontrolled transactions (CUT) identified by petitioner and its adviser, Ernst and Young, LLP (EY), but adjusted the transactions to increase their “profit potential”.
EY relied on the CUT method to determine royalty rates of 29% on intercompany sales of devices and 15% on intercompany sales of leads. EY determined that a royalty rate of 8% for the trademarks was arm’s length.
The Puerto Rico MOU reflected an agreement at the end of the audit which was royalty rates of 44% for devices and 26% for leads to be paid by MPROC on its intercompany sales.
The Puerto Rico MOU also included a profit split methodology that calculated the combined profit from manufacturing and distribution (system profit) that Medtronic US, MPROC, and Med USA were to earn on sales of products manufactured and sold by MPROC. Specifically, the agreed system profit for MPROC was 38% for devices and 45% for leads, with the acceptable range extending to 3% on either side of the target--35%-41% for devices and 42%-48% for leads. 7
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8. Audits and Notice of Determination (II)TP
Audits and Notice of Determination (II)
Audits for 2005 and 2006 Tax Returns.
In March 2010, returned the case to the Internal Revenue Service’s examination function, which reexamined Medtronic’s 2005 and 2006 tax returns.
On December 23, 2010, IRS issued petitioner a notice of deficiency determining deficiencies in tax totaling $198,232,199 and $759,383,578 for 2005 and 2006, respectively. These deficiencies were calculated in reliance on the Heimert report, which used the comparable profits method (CPM). 8
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9. Facts under dispute (2016) – Tax CourtTP
Facts under dispute (2016) – Tax Court
whether income related to intercompany licenses for the intangible property required to manufacture medical device pulse generators (devices) and physical therapy delivery devices (leads) should be reallocated from Medtronic Puerto Rico Operations Co. (MPROC), for tax years 2005 and 2006 (devices and leads transfer pricing issue);
whether Medtronic Europe, S.a.r.L. (Medtronic Europe) made arm’s-length payments to Medtronic US or accrued royalties in excess of arm’s length to manufacture devices sold to Medtronic USA, Inc. (Med USA), pursuant to a supply agreement effective as of May 1, 2002, among Medtronic US, MPROC, and Medtronic Europe (Swiss supply agreement issue);
and alternatively, whether Medtronic US, Med Rel, Inc., or Medtronic Puerto Rico, Inc., transferred intangible property compensable to MPROC when Medtronic US restructured its Puerto Rican operations in 2002 (section 367(d) issue). 9
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10. Medtronic arguments CUT + Profit Split TP
In 2006 the MOU royalty rate was 44% for devices and 26% for leads after the profit split calculation.
Argues that, using the CUT method, the proper arm’s-length royalty rates were 29% for devices and 15% for leads.
Tax authority’s allocations in the notice of deficiency using the CPM are much greater than arm’s length and are therefore arbitrary, capricious, and unreasonable.
argues that respondent’s value chain approach fails to respect and view separately the intercompany transactions between MPROC, Medtronic US, and Med USA. Also contends that respondent did not adequately consider that product quality determines success in the implantable medical device industry and that MPROC is ultimately responsible as the manufacturer of class III finished medical devices. 10
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11. Tax authority argumentTP
Tax authority argument
CPM annual value chain method
CPM definition: CPM evaluates whether the amount charged in a controlled transaction is arm’s length according to objective measures of profitability (profit level indicators) derived from transactions of uncontrolled taxpayers that engage in similar business activities under similar circumstances.
CPM is the best method to determine the arm’s-length royalty rates on the intercompany sales of devices and leads and that making the accompanying section 482 adjustments did not result in an abuse of discretion.
Argues that Medtronic US and Med USA performed all but one of the economically significant functions for CRDM and Neuro.
Medtronic's use of the CUT method does not meet the standard of section 482 and the accompanying regulations. 11
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12. TP
Tax Court decision
“Because of respondent’s approach, and because we have concluded that neither party’s transfer pricing analysis was reasonable, we are left with little help from the parties to determine the proper method.”
“The CUT is a proper method to determine taxable income in connection with a transfer of intangible property.”
“We do not think it is necessary to revise all four transactions to reach an arm’s-length result when only one of the four transactions is not arm’s length. We do not agree with respondent (tax authority) that his approach is the best method and that adjustments could not be made to the one troubling area of petitioner’s methodology--the royalty rates for the licensing of intangibles for devices and leads. We conclude that appropriate adjustments should be made to petitioner’s CUT.” 12
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13. Court of Appeal ( Eight circuit)TP
Court of Appeal ( Eight circuit)
The Eighth Circuit held that the Tax Court had rejected the Commissioner’s transfer-pricing method, and adopted that of the taxpayer, without first engaging in the analysis required under Treasury’s transfer-pricing regulations.  Because the Tax Court failed to make the necessary factual findings under those regulations, the Eighth Circuit was unable to determine whether the court “applied the best transfer pricing method for calculating an arm’s length result or whether it made proper adjustments under its chosen method.”  Accordingly, it vacated the Tax Court’s order and remanded the case for further consideration by the Tax Court. 
The appeals court held that the tax court's factual findings were insufficient to enable the court to conduct an evaluation of the tax court's determination that the Pacesetter agreement was an appropriate comparable uncontrolled transaction (CUT) because it involved similar intangible property and had similar circumstances regarding licensing. In this case, the tax court did not address in sufficient detail whether the circumstances of the settlement between Pacesetter and Medtronic US were comparable to the licensing agreement between Medtronic and Medtronic Puerto Rico; did not analyze the degree of comparability of the Pacesetter agreement's contractual terms and those of the Medtronic Puerto Rico licensing agreement; did not evaluate how the different treatment of intangibles affected the comparability of the Pacesetter agreement and the Medtronic Puerto Rico licensing agreement; and did not decide the amount of risk and product liability expense that should be allocated between Medtronic US and Medtronic Puerto Rico. 13
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14. Questions? Questions? Index 14 Taking control of the future
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