The Tax Court decided to disregard both the IRS’s and the assessee’s transfer pricing analysis by adopting an unspecified method. As for the background: Medtronic US (Parent Company) is a manufacturer and distributor of implantable medical devices. It entered into Intercompany Agreements with its subsidiary in Puerto Rico ("MPR") to receive royalties for use of its intangible assets by MPR. The IRS alleged that the royalties paid by MPR were not at arm’s length and must be adjusted using the Comparable Profits Method (CPM). The Court rejected this method for various reasons, including – MPR’s insignificant quality control function; 2) The significant difference in the model used by comparables; and 3) an inadequate profit level indicator. Whereas the Court rejected the assessee’s method of Comparable Uncontrolled Transaction (CUT) for the following reasons – 1) the different scope of the intangible property licenses; 2) the failure to analyze devices and leads separately when adjusting the royalty rates in the agreements; and 3) failure to include a profit-based analysis.
The Court’s unspecified method (first proposed by Medtronic) integrated both CPM and CUT and had three steps – 1) the Tax Court generated a modified CUT profit result plus trademark license fees for Medtronic US; 2) the Tax Court generated a modified CPM result, net of component and distribution costs, on behalf of Puerto Rico; and 3) the Court split the residual of the system profits 80 percent in favor of Medtronic US and 20% for MPR. According to the Court, this “best method” was to reconcile the flaws of CUT and CPM.