Medtronic Litigation: Unspecified Methods vs. Traditional Methods

In an upcoming Tax Notes International discussion of the second Tax Court decision involving the intercompany royalty rate paid by Medtronic’s Puerto Rican affiliate, I criticize the application of the court's unspecified method on several grounds. Part of the concern was what appeared to be an unrealistically high assertion with respect to the routine return for the Puerto Rican device assembly operations. The other concern was the odd and seemingly arbitrary allocation of residual profits.

This discussion will present a simplified illustration of the various issues with respect to the application of this odd unspecified method in contrast to the extreme profits based approach preferred by the IRS, as well as a more reasonable profits-based approach based on sound financial economic reasoning.

Table 1 presents the basic financial information. Income statements are presented for the US distribution affiliate, the Puerto Rican device assembly affiliate, and the US affiliate that manufactures components. Table 1 assumes that sales of Cardiac Rhythm Disease Management products are $5 billion per year with US selling costs represent 24% of sales, US production costs of components representing 8% of sales, and Puerto Rico assembly costs representing 8% of sales. Combined profits are therefore 60% of sales or $3 billion per year.

The allocation of these profits depends on the intercompany pricing policies, including the price paid by the Puerto Rican affiliate for components, the price charged to the distribution affiliate for finished goods, and the intercompany royalty rate paid by the Puerto Rican affiliate for the use of US-owned intangible assets. Table 1 defers any consideration of intercompany royalties, which I address later. Table 1 assumes that the distribution affiliate receives a 30% gross margin, which is consistent with an intercompany price paid to the Puerto Rican affiliate of $3.5 billion (I/C price 1) . This intercompany pricing policy affords this affiliate with a 6% operating margin. The Puerto Rican affiliate pays the US component manufacturer an intercompany price $500 million (I/C price 2), which is consistent with production costs plus a 25% markup. Note the Puerto Rican affiliate retains profits of $2.6 billion before any intercompany royalty expense.

Table 1: Income Statements of Three Medtronic Affiliates (in USD Millions)

Table 2 presents three applications of unspecified methods for the evaluation of the appropriate intercompany royalty rate. The routine return for each function can be reasonably assumed to represent a 25% markup over costs. The routine return for the US selling (RR Selling) function would be $300 million per year or 6% of sales, which is consistent with the assumed intercompany pricing policies. The routine return for manufacturing components (RR Components) would be $100 million per year or 2% of sales, which is also consistent with the intercompany pricing policies. Our first application of the unspecified method (USM-a) reasonably assumes that the routine return for device assembly (RR Devices) is also $100 million per year or 2% of sales. Residual profits, which is defined as combined profits minus these routine returns, would therefore be $2.5 billion per year or 50% of sales.

Rather than splitting residual profits, the unspecified method relied on a questionable application of the Comparable Uncontrolled Transaction (CUT) approach to assign a royalty rate for the use of product and marketing intangibles, which table 1 assumes to be 10% of sales. Remaining profits are defined as residual profits minus this CUT estimate of the value of product and marketing intangibles. Remaining profits in this application would represent 40% of sales.

Remaining profits are akin to goodwill in purchase price allocations. Many purchase price allocations assign values to tangible assets and identifiable intangible assets and then define goodwill as the purchase price minus these assigned values. If goodwill represents a significant portion of the purchase price, one must wonder how much of this goodwill represents the value of unidentified intangibles such as process intangibles versus a tacit admission that the analysis underestimated the value of the identified intangible assets. While the representatives of Medtronic asserted that the Puerto Rican affiliate possessed valuable process intangibles, no analysis of the profits for these alleged intangibles was offered. Another explanation for the high remaining profits may be that the profit potential for the Medtronic product and marketing intangibles was significantly greater than the profit potential for the third-party licensing agreements.

In addition to USM-a, Table 2 also presents applications of Medtronic's proposed unspecified method (USM-b) and the unspecified method adopted by the court (USM-c).

Table 2: Three Applications of the Odd Unspecified Method (in USD Millions)

The expert witness for Medtronic arbitrarily assumed that remaining profits should be allocated equally between the Puerto Rican affiliate and the US parent. Our first version of this model results in total US intangible profits being 30% of sales, which is consistent with the conclusion of the first trial court decision. Total US profits would be $1.9 billion per year with the Puerto Rican affiliate receiving $1.1 billion per year in profits or 36.67% of total profits.

The expert witness for Medtronic also arbitrarily assumed a very high routine return for the assembly operations. The next two applications of this odd unspecified model assumes that the routine return for assembly represents 12% of sales. Residual profits for both USM-b and USM-c would be only 40% of sales as total routine returns increase to 20% of sales. If we retain the 10% CUT assumption then remaining profits would be only 30% of sales. Model USM-b retains the assumption that the remaining profits are allocated equally. The implications of this application of the unspecified method is that the royalty rate should be only 25% of sales, which leaves the Puerto Rican affiliate with 45% of combined profits.

The second trial court decision noted how the judge was not comfortable with the Puerto Rican affiliate receiving such a high share of overall profits. This decision, however, did not challenge the assumptions of routine return, including the very high routine return assigned to the assembly operations. The modification made by the trial court was to assign a larger share of remaining profits to the US parent. Our application USM-c explores the implication of letting the US share of remaining profits be 83.33%. In this case, the royalty rate rises to 35% of sales with the share of overall profits accruing to the Puerto Rican affiliate falling to 28.33%.

More Traditional Approaches

These applications of the unspecified method rely on arbitrary assumptions and are not based either on sound financial economics or the facts in this litigation. Table 2 explores two traditional approaches that rely on the sensible routine return estimates assumed in our USM-a application of the unspecified method.

Traditional approaches include the one-sided Transactional Net Margin Method (TNMM, known as the Comparable Profits Method in the US) and Residual Profit Split Method (RPSM). Unlike the unspecified methods in the Medtronic case, RPSM directly addresses the allocation of residual profits rather than first applying a royalty rate for use of the intangibles. Table 3 assumes that residual profits and remaining profits are equal.

Table 3: Two Traditional Approaches (in USD Millions)

The IRS application of TNMM assumes that the intercompany royalty rate should be equal to residual profits on the grounds that the US parent owns all valuable intangible assets. Its approach would result in a 50% royalty rate, which would leave the Puerto Rican affiliate with only 3.33% of combined profits. This extreme approach effectively treats the Puerto Rican affiliate as a contract manufacturer owning no valuable intangible assets and bearing little commercial risk.

I criticized this approach in a February 2019 piece in the Journal of International Taxation on financial economic grounds, noting that licensees bear additional commercial risk when licensing a valuable intangible asset owned by another entity. My application of this model suggests a Residual Profits Split Method even if the licensee does not own valuable intangible assets. In my discussion of this risk/expected return approach applied to the Medtronic litigation, I suggested that the licensee deserved 30% of residual profits. In this case, the arm’s length royalty rate would be 35% of sales leaving the Puerto Rican affiliate with 28.33%.

Note that this RPSM approach led to the same result as our representation of how the trial court applied the unspecified method. In other words, the second trial court may have reached a reasonable result even if the unspecified method rested on illogical foundations.

Concluding Remarks

The first trial court decision concluded that a 30% royalty rate was reasonable. The second trial court increased this royalty rate to 33.2% based on an application of the unspecified method similar to what we have described as application U-c.  Whether or not a 33.2% royalty rate was the right answer, the unspecified method was so convoluted that the process of arriving at this result was certainly not sound reasoning. Sound reasoning would follow the process outlined in Section 1.482-6 with one additional step to account for the additional share of residual profits that should accrue to the licensee for bearing additional commercial risk when utilizing a valuable intangible asset owned by another entity. The process would begin with a clear estimate of expected operating profits relative to sales followed by reliable estimates for the routine returns for production and distribution. These steps would define residual profits. If the licensee owned a portion of the valuable intangible assets, estimates of the relative values of the intangible assets owned by the licensor and the licensee are required under Section 1.482-6. Even if the licensee does not own valuable intangible assets, it deserves a share of residual profits for bearing additional commercial risk when utilizing a valuable intangible asset owned by another entity.

References

Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue Service, T.C. Memo. 2022-84, August 18, 2022.

Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue Service, T.C. Memo. 2016-112, June 9, 2016

Harold McClure, “Medtronic’s Intercompany Royalty Rate: Bad CUT or Misleading CPM?”, Journal of International Taxation, February 2019.