Addressing whether certain intercompany technology license agreements were negotiated at arm’s length, the US Tax Court rejected the Internal Revenue Service’s (IRS) alleged $1.36 billion tax deficiency and determined that the royalty rates in question were appropriate because the licensee’s actions formed the foundation of the product’s success. Medtronic, Inc. v. Commissioner, TC Memo. 2016-112 (Tax, June 9, 2016) (Kerrigan, J).

To prevent tax evasion and ensure that taxpayers appropriately allocate taxable income between related entities, intercompany agreements must be negotiated at arm’s length. At issue here was whether intercompany license agreements for medical device technology between Medtronic entities in the United States and Puerto Rico met this requirement.

Medtronic is a leading medical technology company that operates in multiple countries. Among its product offerings are implantable medical devices that, once implanted in the human body, including in the patient’s heart, analyze cardiac signals and apply therapeutic actions. Because failure of these devices can have severe consequences for the patient, including death, the US Food and Drug Administration (FDA) scrutinizes these implantable medical devices and requires them to meet strict safety and quality standards. The market also values implantable medical devices that are of high quality and have low failure rates.

Medtronic US and Medtronic’s Puerto Rico subsidiary, MPROC, entered into intercompany licenses for patents, trade secrets and other intellectual property used to manufacture implantable medical devices. Under the license agreements, MPROC gained the right to use the intellectual property to manufacture the medical devices and paid Medtronic US a 44 percent royalty for the devices and a 26 percent royalty for the leads. MPROC ensured a high-quality product by, among other things, firing employees responsible for even a single product defect.

The IRS analyzed the taxes that the Medtronic entities paid in 2005 and 2006, and determined that the parties were shifting too much taxable income to MPROC. In its notice of deficiency, the IRS stated that the Medtronic entities had a $1.36 billion tax deficiency.

The Tax Court determined that the IRS’s tax deficiency calculations were arbitrary and capricious. The IRS had argued that the royalty rates were too low because MPROC merely manufactured a standard product under Medtronic US’s supervision. According to the IRS, Medtronic’s success was attributable not to the product quality contributed by MPROC, but to Medtronic’s large product line and sales force. The Court rejected this argument, finding that for these implantable medical devices, product quality was the foundation for success. If the medical device fails, the patient can die. MPROC was responsible for, and used its expertise to ensure, a high-quality, FDA-compliant product. Because MPROC was responsible for the success of the product, the Court rejected the IRS’s analysis and determined an arm’s length royalty to be 44 percent for the devices and 22 percent for the leads.