Medtronic's Transfer Pricing Dispute with IRS: Benchmarking Intangible Assets in Focus

Medtronic and its subsidiary, Medtronic Puerto Rico, have been in dispute with the IRS regarding the transfer pricing method used for intellectual property (IP). Medtronic is a global manufacturer of medical devices and therapies, including insulin pumps, pacemakers, and diabetes treatments. Based on the Medtronic v. Commissioner case, it’s safe to say that intangible assets are always a challenge to benchmark.

The case’s significance lies in the existence of a prior arm’s-length agreement, known as the Pacesetter Agreement, which Medtronic had negotiated with a major competitor. This third-party agreement established industry-leading royalty rates and future licensing rights and was later adopted by another competitor, remaining in effect during the tax years in question. The central question is whether the Pacesetter Agreement can be used as a valid benchmark to determine appropriate royalty rates in the controlled transaction between Medtronic and its Puerto Rico subsidiary, given that both agreements substantially involve the same patents.

For the arm’s-length royalty rate, Medtronic utilized the Comparable Uncontrolled Transaction (CUT) method to justify the Medtronic P.R. licensing rate. According to the Intercompany Transfer Pricing Regulations Under Section 482, 59 Fed. Reg. 34,971, 34,983, the CUT method “determines an arm’s-length royalty for an intangible by reference to uncontrolled transfers of comparable intangible property under comparable circumstances.”

The regulatory framework explicitly acknowledges that transactions between unrelated parties serve as the most objective benchmark for assessing the arm’s-length nature of controlled transactions. This principle is written in Treasury Regulation §1.482-1(c)(2), which emphasizes the foundational importance of unrelated party transactions in transfer pricing analyses. Furthermore, the Commissioner’s endorsement of the CUT method as generally providing the most direct and reliable measure of an arm’s-length result reinforces its significance in transfer pricing method determinations.

The IRS was not supportive of Medtronic’s approach and argued that using Medtronic’s licensing agreement as a benchmark for this intercompany licensing transaction was not appropriate because intercompany licensing transactions involve additional intangible assets such as trade secrets, certain copyrights and know-how, whereas the Pacesetter Agreement only included patents.

The IRS suggested that the Comparable Profit Method (CPM) should have been used, considering the significant differences between the two transactions. CPM evaluates whether the pricing in a controlled transaction meets the arm’s-length standard by using objective profitability measures, known as profit level indicators. These indicators are based on the financial data of uncontrolled taxpayers involved in similar business activities under comparable conditions.

As we closely monitor this case’s conclusion, the challenges of benchmarking intangibles remain unchanged. It may be wise to avoid directly valuing intangible assets and instead rely on the most appropriate measure of profitability suitable to the nature of the transaction. Contact McGuire Sponsel’s Global Business Services team with any questions.