Transfer Pricing Court Case Updates

U.S. Federal Courts reached two important decisions on transfer pricing cases as 2022 came to a close. The U.S. Court of Appeals for the Sixth Circuit decided in Eaton Corp. and Subsidiaries v. Commissioner, that the IRS must apply contract law to advance pricing agreements. In Medtronic Inc. v. Commissioner, the U.S. Tax Court showed in its decision that it may be beneficial for litigants of transfer pricing cases to consider a convergence of methods when presenting their transfer pricing reports.

Eaton Corp. and Subsidiaries v. Commissioner
On August 25, 2022, the Sixth Circuit determined that the IRS had the burden of proving that there were grounds to cancel APAs under generally applicable contract-law principles and the IRS failed to meet that burden.

This opinion is unlikely to change the transfer pricing landscape for other taxpayers because the Sixth Circuit considered Eaton’s unique facts within the terms of the agreed upon APAs. However, the decision, in confirming that APAs are subject to contract law principles and the IRS has the burden of proof to show the grounds supporting an APA cancellation, raises the threshold the IRS must meet in order to cancels APAs. This should ultimately give taxpayers confidence that their agreed upon APAs with the IRS cannot be cancelled, so long as the taxpayer remains in alignment with the terms of the APA.

Medtronic Inc. v. Commissioner
The Tax Court’s opinion in Medtronic III highlights the importance of considering all transfer pricing methods available before coming to the best method. In this case, the Court determined that Medtronic and the IRS each presented incomplete methods for determining arm’s-length royalty rates. Medtronic had tried to use CUT methods, while the IRS posited that the CPM was the best method. In light of this, the Court requested that Medtronic and the IRS establish a new transfer pricing procedure that included averaging the CPM and the CUT method. In its review of the new unspecified methods, the Court determined that the IRS did not go far enough to converge the CPM and CUT method together to best address the Taxpayer’s situation. Medtronic, on the other hand, presented two versions of an unspecified method combining elements of the CUT method and the CPM. As a result, the Court decided that Medtronic’s unspecified method was the best method to use given the specific facts and circumstances of the case. Even with this decision, Medtronic still received unfavorable adjustments to its transfer pricing from the Court. However, these adjustments were considerably less than what the IRS was originally targeting from Medtronic.

This case is important for three reasons. First, it highlights the need for taxpayers to consider all transfer pricing methods available, while also providing strong reasoning for the selection of the best method selection. Second, this case show that taxpayers can expect that the IRS will consider alternative methods that the taxpayer should be ready to defend against. Finally, this case shows that Courts can consider a blend of methods and taxpayers should be prepared to be flexible in their transfer pricing methods if they wish to receive a favorable ruling, such as Medtronic.

Conclusion
While these cases cover different aspects of transfer pricing, they should both highlight the need for taxpayers to have robust transfer pricing procedures. The cases demonstrate the IRS’ willingness to push back on taxpayer’s transfer pricing policies. The best defense to this push back is well thought out transfer pricing procedures, supported by strong transfer pricing documentation, in line with IRS and OECD regulations.

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