Taxpayer wins big in transfer-pricing dispute.

• Author: Beavers, James A.
• Position: 2016 Tax Court memorandum decision in Medtronic, Inc. v. Commissioner

The Tax Court held that the IRS had abused its discretion in reallocating income related to intercompany licenses for the intangible property required to manufacture certain cardiac and neurological implantable medical devices from a Puerto Rican company to its U.S. parent company.

Background

Medtronic Inc. (Medtronic) is a large medical technology company based in the United States with worldwide operations and sales. It operates in more than 120 countries and has over 33,000 employees. The company has multiple business units that make a wide range of products, including a cardiac rhythm disease management (CRDM) unit and a neurological (Neuro) unit. Among the products these two units make are various medical device pulse generators (devices) and physical therapy delivery units (leads). These two types of medical products are classified by the Food and Drug Administration as Class III medical devices because they are life-supporting or fife-sustaining. In the years in question, Medtronic was the dominant company in the market for both CRDM and Neuro devices and leads.

Medtronic US: Medtronic US is the headquarters of Medtronic's CRDM and Neuro businesses and is responsible for research and development for new and existing products (including devices and leads) and meeting global regulatory requirements for them. Medtronic US also manufactured components for devices and leads through several vertically integrated component manufacturing branches. Its subsidiary, Medtronic Puerto Rico Operations Co. (MPROC), purchased and used some of these components to manufacture devices and leads and sold some of the devices and leads it manufactured to Med USA, another Medtronic US subsidiary, which sold them in the United States and other jurisdictions.

MPROC: Medtronic initially set up two companies in Puerto Rico in the 1970s to take advantage of the favorable Sec. 936 possession corporation rules. After Congress announced the phaseout of Sec. 936 benefits, Medtronic US reorganized the Puerto Rican companies into MPROC, a branch of Medtronic Holding Switzerland GmbH, a controlled foreign corporation. MPROC received an industrial tax exemption from Puerto Rico, which provided that income from certain products of the company was not subject to Puerto Rican income tax. Having this exemption meant that the company paid no tax to Puerto Rico on the income from its CRDM and Neuro products.

MPROC's devices and leads operations were FDA-registered facilities that manufactured Class III finished medical devices. However, the company did far more than simply put together components from Medtronic US, and its operations were substantially autonomous from Medtronic US. MPROC was separately responsible for its own operations, developed its own IT systems that improved product quality, provided training for physicians, designed and reviewed its manufacturing processes, and otherwise was involved in every aspect of the manufacturing process for leads and devices. Because the lives of patients who received a lead or device the company produced literally depended on their functioning properly, quality control was of extremely high importance in its manufacturing process.

License agreements: Medtronic US and MPROC entered into license agreements, effective as of Sept. 30, 2001, for the intangible property used in manufacturing devices and leads. Under the devices and leads licenses, MPROC obtained the exclusive right to use, develop, and enjoy the intangible property used in manufacturing devices for sale to customers...