Recent ruling by Tax Court provides transfer pricing guidance

In August 2022, the US Tax Court (Tax Court) issued an opinion, T.C. Memo 2022-84, that increases the royalty rate on licensing agreements between a US parent company and its Puerto Rican subsidiary. In doing so, it rejected the transfer pricing analysis applied by both the IRS and the taxpayer and applied an unspecified method to determine the appropriate rate on the intangible property. The ruling provides guidance and insight for other related-party transactions.

Background of T.C. Memo 2022-84

The IRS enacted new pricing rules under Section 482 of the Internal Revenue Code to impede tax evasion and to secure the accurate reporting by taxpayers of income relating to transactions between controlled entities. Through Section 482, the IRS is authorized to allocate the gross income, deductions, credits or allowances between two related corporations, if necessary, to prevent tax evasion or to clearly reflect the income of those parties.

The transfer pricing transaction in this case involves intercompany licensing agreements between Medtronic, a US multinational company that manufactures and sells medical devices, and its Puerto Rican subsidiary. The licensing agreements established the royalty rate the Puerto Rican subsidiary (Med PR) paid Medtronic US (Med US) for the use of intangible assets by Med PR in its additional development, manufacturing and commercialization of medical devices.

When a transaction takes place between two related parties, an arm’s-length standard is used for determining true taxable income, ensuring that both parties are acting independently and in their own self-interest. There are four methods provided by the regulations to decide the proper amount to be charged in such a controlled transfer of intangible property: the comparable uncontrolled transaction method (CUT), the cost plus method (CPM), the profit split method and unspecified methods.

To comply with the Section 482 transfer pricing rules, Med US used the CUT method to establish an arm’s-length royalty rate on the intercompany agreements. By referencing the amount charged in a comparable transaction between independent, unrelated parties, the CUT method evaluates whether the amount charged for a controlled transfer of intangible property was made at a fair, arm’s-length rate.

Treas. Reg. § 1.482-4(c)(1).

In order for intangibles to be considered comparable, both intangibles must 1) be used in connection with similar products or processes within the same general industry or market and 2) have similar profit potential. When the IRS audited Med US’s return, it determined that the CUT method applied by Med US was not appropriate and allowed the company to shift profit to Puerto Rico to avoid US taxes.

The IRS concluded a modified CPM should be used instead of the CUT method to determine the appropriate transfer price. According to the US Department of the Treasury, the CPM “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.”1

The method used by the IRS split the profit from the medical devices in a manner that allocated 90% to Med US and 10% to Med PR. The IRS justified this result by establishing profit level indicators from uncontrolled transactions that it deemed similar in nature.

First Tax Court opinion

Med US disputed the result reached by the IRS and filed suit in the Tax Court, arguing that its CUT method was a better approach than the IRS’s CPM analysis. The Tax Court rejected both Med US’s CUT method and the IRS’s CPM analysis in their initial opinion.

Instead, the Tax Court applied an unspecified method that used an agreement entered into with an uncontrolled taxpayer, referred to as the Pacesetter Agreement, as the basis for its own CUT method. Adjustments to the Pacesetter Agreement, including those for know-how, profit potential and differences in intangible property, were made by the Tax Court to reach the appropriate arm’s-length amount.

The Tax Court’s decision stated that the royalty rates would be 44% for devices and 22% for leads. Leads are highly complex wiring systems that connect medical devices to the human body.

Appeals Court opinion

The IRS was not satisfied with the result reached by the Tax Court and appealed to the Eighth Circuit Court of Appeals, hoping to get a different result. The Eighth Circuit Court of Appeals found that there were not sufficient factual findings and analysis to determine whether the best transfer pricing method was applied, so the case was remanded to the Tax Court.

Second Tax Court opinion

After the Tax Court reevaluated the case, it concluded the Pacesetter Agreement wouldn’t be treated as a modified CUT but could be used as a starting point in determining a proper royalty rate under an unspecified method because the terms of the payments were comparable. Both agreements contained running royalty rates based on sales of devices and leads.

The Tax Court requested that Med US and the IRS provide alternative methods for arriving at an arm’s-length royalty rate after rejecting both Med US’s CUT method and the IRS’s CPM approach. Two versions of an unspecified method combining elements of the CUT method and the CPM analysis were proposed by Med US. The IRS did not provide an alternative method and maintained the CPM approach was the best option.

Under both of Med US’s proposals, step 1 and step 2 were the same. Step 1 was a modified CUT method that used the Pacesetter Agreement to allocate profit to Med US. Step 2 was a modified CPM and required an upward adjustment to Med PR’s operating asset base to allocate profits based on a return on assets (ROA) consistent with the average ROA used by the IRS in its CPM analysis.

Step 3 provided two options for allocating the remaining profit. The first option resulted in an overall royalty rate of 35.7%, and the second option resulted in an overall royalty rate of 40%.

The Tax Court followed steps 1 and 2 of Med US’s proposed alternatives, but for step 3 it used a profit split that allocated a higher percentage to Med US than either of the proposed options. The Tax Court explained that allocating more profit to Med US in step 3 helped compensate for the shortcomings built into the calculations of steps 1 and 2.

The profit split used by the Tax Court resulted in an overall royalty rate of 48.8% on both devices and leads. This result raised the royalty rate relative to its previous decision, which established a 44% rate for devices and 22% rate for leads.

The Tax Court’s analysis provides guidance for other related-party transactions. One of the key takeaways here is that the Tax Court followed the comparability framework outlined in the transfer pricing regulations and made adjustments to established methods to create an unspecified method that represented the “best method” for determining an arm’s-length price.

Tara Fisher has been practicing tax for over 20 years. Her professional background includes working for the US Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh and American University in Washington DC. She is a licensed CPA and holds both an undergraduate and a graduate degree in accounting from the University of Virginia.

The content contained in this article is for informational purposes only and is not tax advice. You should consult a tax advisor for advice applicable to your situation.

References

1. 26 C.F.R. § 1.482-5(a). US Department of the Treasury, 1 Apr. 2021. https://www.govinfo.gov/content/pkg/CFR-2021-title26-vol8/pdf/CFR-2021-title26-vol8-sec1-482-5.pdf