Medtronic had used the comparable uncontrolled transactions (CUT) method to determine the arm’s length royalty rates received from its manufacturing subsidiary in Puerto Rico for use of IP under an inter-group license agreement. The tax authorities found that Medtronic left too much profit in Puerto Rico. Using a “modified CPM” the IRS concluded that at arm’s length 90 percent of Medtronic’s “devices and leads” profit should have been allocated to the US parent and only 10 percent to the operations in Puerto Rico. Medtronic brought the case to the Tax Court. The Tax Court applied its own analysis and concluded that the Pacesetter agreement was the best CUT to calculate the arm’s length result for license payments. This decision from the Tax Court was then appealed by the IRS to the Court of Appeals. In 2018, the Court of Appeal found that the Tax Court’s factual findings had been insufficient. The Court of Appeals stated taht: “The Tax Court determined that the Pacesetter agreement was an appropriate comparable uncontrolled transaction (CUT) because it involved similar intangible property and had similar circumstances regarding licensing. We conclude that the Tax Court’s factual findings are insufficient to enable us to conduct an evaluation of that determination.” The Tax Court did not provide (1) sufficient detail as to whether the circumstances between Siemens Pacesetter, Inc. (Pacesetter), and Medtronic US were comparable to the licensing agreement between Medtronic US and Medtronic Puerto Rico (MPROC) and whether the Pacesetter agreement was one created in the ordinary course of business; (2) an analysis of the degree of comparability of the Pacesetter agreement’s contractual terms and those of the MPROC’s licensing agreement; (3) an evaluation of how the different treatment of intangibles affected the comparability of the Pacesetter agreement and the MPROC licensing agreement; and (4) the amount of risk and product liability expense that should be allocated between Medtronic US and MPROC. According to the Court of Appeal these findings were “… essential to its review of the Tax Court’s determination that the Pacesetter agreement was a CUT, as well as necessary to its determination whether the Tax Court applied the best transfer pricing method for calculating an arm’s length result or whether it made proper adjustments under its chosen method“. Hence, the case was remanded to the Tax Court for further considerations. Opinion of the US Tax Court Following the re-trial, the Tax Court concluded that the taxpayer did not meet its burden to show that its allocation under the CUT method and its proposed unspecified method satisfied the arm’s length standard. “Increasing the wholesale royalty rate to 48.8% results in an overall profit split of 68.72% to Medtronic US/Med USA and 31.28% profit split to MPROC and a R&D profits split of 62.34% to Medtronic US and 37.66% to MPROC. The resulting profit split reflects the importance of the patents as well as the role played by MPROC. The profit split is more reasonable than the profit split of 56.8% to Medtronic US/Med USA and 43.2% to MPROC resulting from petitioner’s unspecified method with a 50–50 allocation. According to respondent’s expert Becker, MPROC had incurred costs of 14.8% of retail prices. The evidence does not support a profit split which allocates 43.2% of the profits to MPROC when it has only 14.8% of the operating cost.” “We conclude that wholesale royalty rate is 48.8% for both leads and devices, and the royalty rate is the same for both years in issue. According to the regulations an unspecified method will not be applied unless it provides the most reliable measure of an arm’s-length result under the principles of the best method rule. Treas. Reg. § 1.482-4(d). Under the best method rule, the arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable method of getting an arm’s-length result. Id. § 1.482-1(c)(1). We have concluded previously that petitioner’s CUT method, petitioner’s proposed unspecified method, the Court’s adjusted CUT method in Medtronic I, respondent’s CPM, and respondent’s modified CPM do not result in an arm’s-length royalty rate and are not the best method. Only petitioner suggested a new method, its proposed unspecified method; however, for reasons previously explained, that method needed adjustment for the result to be arm’s length. “Our adjustments consider that the MPROC licenses are valuable and earn higher profits than the licenses covered by the Pacesetter agreement. We also looked at the ROA in the Heimert analysis and from the evidence cannot determine what the proper ROA should be. The criticisms each party had of the other’s methods were factored into our adjustment. Respondent’s expert Becker testified that you may not like the logic of a method but ultimately the answer is fine. Because neither petitioner’s proposed CUT method nor respondent’s modified CPM was the best method, our goal was to find the right answer. The facts in this case are unique because of the complexity of the devices and leads, and we believe that our adjustment is necessary for us to bridge the gap between the parties’ methods. A wholesale royalty rate of 48.8% for both devices significantly bridges the gap between the parties. Petitioner’s expert witness Putnam proposed a CUT which resulted in a blended wholesale royalty rate of 21.8%; whereas respondent’s expert Heimert’s original CPM analysis resulted in a blended wholesale royalty rate of 67.7%. In Medtronic I we concluded that the blended wholesale royalty rate was 38%, and after further trial, we conclude that the wholesale royalty rate is 48.8%, which we believe is the right answer.” Click here for other translation ...

Amgen, in a note to its financial statement for the quarterly period ended June 30, 2021, disclosed that it has been issued tax assessments of approximately $3.6b plus interest for tax years 2010, 2011 and 2012 by the IRS. Proposed adjustments for FY 2013, 2014 and 2015 has also been issued.  The dispute relates to the allocation of profits between Amgen group entities in the United States and the U.S. territory of Puerto Rico. According to the note, Amgen has filed a petition in the U.S. Tax Court to contest the assessments. 4. Income taxes The effective tax rates for the three and six months ended June 30, 2021, were 16.8% and 12.6%, respectively, compared with 11.2% and 10.4%, respectively, for the corresponding periods of the prior year. The increase in our effective tax rate for the three and six months ended June 30, 2021, was primarily due to the non-deductible IPR&D expense arising from the acquisition of Five Prime. The effective tax rates differ from the federal statutory rate primarily as a result of foreign earnings from the Company’s operations conducted in Puerto Rico, a territory of the United States that is treated as a foreign jurisdiction for U.S. tax purposes, that are subject to a tax incentive grant through 2035. In addition, the Company’s operations conducted in Singapore are subject to a tax incentive grant through 2034. These earnings are also subject to U.S. tax at a reduced rate of 10.5%. The U.S. territory of Puerto Rico imposes an excise tax on the gross intercompany purchase price of goods and services from our manufacturer in Puerto Rico. The rate of 4% is effective through December 31, 2027. We account for the excise tax as a manufacturing cost that is capitalized in inventory and expensed in cost of sales when the related products are sold. For U.S. income tax purposes, the excise tax results in foreign tax credits that are generally recognized in our provision for income taxes when the excise tax is incurred. One or more of our legal entities file income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and certain foreign jurisdictions. Our income tax returns are routinely examined by tax authorities in those jurisdictions. Significant disputes may arise with tax authorities involving issues regarding the timing and amount of deductions, the use of tax credits and allocations of income and expenses among various tax jurisdictions because of differing interpretations of tax laws, regulations and relevant facts. In 2017, we received a Revenue Agent Report (RAR) and a modified RAR from the Internal Revenue Service (IRS) for the years 2010, 2011 and 2012 proposing significant adjustments that primarily relate to the allocation of profits between certain of our entities in the United States and the U.S. territory of Puerto Rico. We disagreed with the proposed adjustments and calculations and pursued a resolution with the IRS administrative appeals office. As previously reported, we were unable to reach resolution with the IRS appeals office. In July 2021, we filed a petition in the U.S. Tax Court to contest two duplicate Statutory Notices of Deficiency (Notices) for 2010, 2011 and 2012 that we received in May and July 2021. The duplicate Notices seek to increase our U.S. taxable income by an amount that would result in additional federal tax of approximately $3.6 billion, plus interest. Any additional tax that could be imposed would be reduced by up to approximately $900 million of repatriation tax previously accrued on our foreign earnings. In any event, we firmly believe that the IRS’s positions in the Notices are without merit and we will vigorously contest the Notices through the judicial process. In addition, in 2020, we received an RAR and a modified RAR from the IRS for the years 2013, 2014 and 2015 also proposing significant adjustments that primarily relate to the allocation of profits between certain of our entities in the United States and the U.S. territory of Puerto Rico, similar to those proposed for the years 2010, 2011 and 2012. We disagree with the proposed adjustments and calculations and are pursuing resolution with the IRS administrative appeals office. We are currently under examination by the IRS for the years 2016, 2017 and 2018. We are also currently under examination by a number of other state and foreign tax jurisdictions. Final resolution of these complex matters is not likely within the next 12 months. We believe our accrual for income tax liabilities is appropriate based on past experience, interpretations of tax law, application of the tax law to our facts and judgments about potential actions by tax authorities; however, due to the complexity of the provision for income taxes and uncertain resolution of these matters, the ultimate outcome of any tax matters may result in payments substantially greater than amounts accrued and could have a material adverse impact on our condensed consolidated financial statements. We are no longer subject to U.S. federal income tax examinations for the years ended on or before December 31, 2009. During the three and six months ended June 30, 2021, the gross amounts of our unrecognized tax benefits (UTBs) increased $50 million and $110 million, respectively, as a result of tax positions taken during the current year. Substantially all of the UTBs as of June 30, 2021, if recognized, would affect our effective tax rate ...

In this case the IRS was of the opinion, that Medtronic erred in allocating the profit earned from its devises and leads between its businesses located in the United States and its device manufacturer in Puerto Rico. To determine the arm’s length price for Medtronic’s intercompany licensing agreements the comparable profits method was therefor applied by the IRS, rather than the comparable uncontrolled transaction (CUT) used by Medtronic. Medtronic brought the case to the Tax Court. The Tax Court applied its own valuation analysis and concluded that the Pacesetter agreement was the best CUT to calculate the arm’s length result for intangible property. This decision from the Tax Court was then appealed by the IRS to the Court of Appeals. The Court of Appeal found that the Tax Court’s factual findings were insufficient to enable the Court to conduct an evaluation of Tax Court’s determination. Specifically, the Tax Court failed to: address whether the circumstances of the Pacesetter settlement was comparable to the licensing agreements in this case, the degree of comparability of the contractual terms between the two situations, how the different treatment of intangibles affected the two agreements and the amount of risk and product liability expenses that should be allocated. Thus, the case has been remanded for further consideration ...

Reca Química is active in industrial production of paints and synthetic resins. Its parent company is H.B. Fuller which is based in the United States. According to the “Transfer Pricing Policy” set by the parent company of the group and in place since 1992, a 10% margin on sales was applied to inventory transferred between affiliates. However, during the fiscal periods 2003 and 2004, the parent company changed the policy so that sales to related companies abroad were to be made with a profit margin of only 5%, while for local affiliates and independent parties, the margin would be 10%. The tax administration issued an assessment in which the margin of all the controlled transactions was set at 10% resulting in additional taxable income of ¢185,827,941.00. According to the tax administration the 5% margin was not even enough to cover the operating expenses for the transactions in question. In 2015 the Administrative Court of Appeal ruled in favor of Reca Quimica due to formal grounds. However, the assessment was allowed to be issued again in accordance with the guidelines set out in the ruling. An appeal was then filed with the Supreme Court. Judgement of the Supreme Court The Supreme Court upheld the Judgement of the Administrative Court of Appeal, except for allowed claims in respect of the award of damages and interest, which was annulled. The Courts considered that the the authorities had made an error in motivating the adjustment on a presumed basis determination, without complying with the legal requirements established for this type of tax determination. Furthermore, they said that if transfer prices had been determined, the authorities should have applied the adjustment according to one of the methods established by the OECD on a certain basis, and not on a presumed basis. The judicial decision commits, in our opinion, a mistake. The five OECD methods are to determine whether or not there is transfer pricing. These methodologies are designed to examine whether prices between related parties are adjusted or not, to transactions in comparable circumstances between independent parties. But once it has been determined that there are transfer prices, what is appropriate is precisely to adjust them to prices under competitive conditions. The new price must then be set by the authorities, so that it is the basis for determining the corresponding tax obligations.” Excerpts “…this Chamber endorses the Court’s decision, insofar as it ruled that this discrepancy did not allow the use of the presumed basis method. Likewise, it considered, “…this allegation is fallacious, since using a margin in sales to related companies abroad different from that used in sales to other companies is not a true accounting irregularity or defect”. This is due to the fact that the accounting of the plaintiff could not be qualified as omissive, irregular and contradictory, since the taxpayer did not fail to provide information on its transactions, but rather, based on its reality, reported a different, -minor- profit in the transactions carried out with its related companies abroad (regardless of their normality), then the Administration should have applied the method of certain basis, via transfer prices.” “Hence, there is no doubt that what the Administration should have done was to determine, -by using transfer prices- whether the price at which it sold to its related companies abroad was dissimilar to the market price, but never to use, as it did, the estimate based on a presumptive basis. For, as explained above, the plaintiff provided in her declaration information on the price at which she sold to her related companies abroad. According to the OECD (Organisation for Economic Co-operation and Development), there are five approved transfer pricing mechanisms, namely, first, the comparable free price method. Second, the resale price method. Third, the cost plus method. Fourth, the net transaction margin method; and fifth, the profit split method. With regard to this point, Executive Decree no. 37898-H of 5 June 1998 is currently in force in the legal system. 37898-H of 5 June 2013, and at the time of the facts that are of interest in the sub-lite, Interpretative Guideline no. 20-03 was in force, -with support in regulations 8 and 12 of the TC-. The legality of that Guideline was ratified by the Constitutional Chamber since its decision no. 2012-04940 of 15 hours 37 minutes on 18 April 2013. Consequently, the Court rightly stated: “…-based on what was indicated by the Chamber and taking into account the erga omnes binding effect of the constitutional jurisprudence (article 13 of Law 7135)- there is no contradiction between the transfer pricing methodology and the application of the economic reality principle of paragraphs 8 and 12 of the CNPT, nor is there any impediment to resort to the former even in the absence of an express legal rule that incorporates it into the Costa Rican legal system”. Thus, in this case, contrary to what was argued by the Administration, none of the assumptions established in canon 124 of the TC were met, so as to empower it to apply the presumptive basis methodology (article 125 ibid); on the contrary, according to the information provided by the plaintiff in its tax return, what was relevant was the application of the transfer pricing methodology, through any of its five mechanisms, so as to arrive at the correct determination of the tax liability. By not doing so, it is clear, as the judges ruled, that the Administration acted illegally, given that it should have applied the certain base method, which, since it was dealing with a transfer pricing case, should have been examined in accordance with the technical regulations of the OECD, which was feasible in accordance with the legal system in force at that time. Therefore, the complaint should be rejected.” Click here for English translation Click here for other translation ...

In an ongoing transfer pricing battle between Microsoft and the IRS related to Microsofts’ use of a IP subsidiary in Puerto Rico to shift income and reduce taxes, the District Court of Washington has now ordered Microsoft to provide a number of documents as requested by the IRS. In a prior decision from November 2015 the District Court ruled, that the IRS’ use of an external representative was not in conflict with US regulations. Microsoft argued that the IRS’ use of an outside law firm, Quinn Emanuel Urquhart & Sullivan, to assist in the audit was an improper delegation of its authority to examine taxpayer books. The Court ruled that the government had a legitimate purpose in continuing to pursue the audit, and that the use of Quinn Emanuel was not a breach of IRS authority that would invalidate the summonses. “The court’s role in this matter is not to pass judgment on the IRS’ contracting practices, but to enforce or not enforce the summonses,” Martinez wrote. The law allows the IRS some flexibility in its use of outside contractors, he said, and Microsoft’s characterization of the role of Quinn Emanuel “greatly exceeds what is evident in the record.” ...

The IRS argued that Medtronic Inc failed to accurately account for the value of trade secrets and other intangibles owned by Medtronic Inc and used by Medtronic’s Puerto Rico manufacturing subsidiary in 2005 and 2006 when determening the royalty payments from the subsidiary. In 2016 the United States Tax Court found in favor of Medtronic, sustaining the use of the CUT method to analyze royalty payments. The Court also found that adjustments to the CUT were required. These included additional adjustments not initially applied by Medtronic Inc for know-how, profit potential and scope of product. The decision from the United States Tax Court has been appealed by the IRS in 2017 ...

Reca Química is active in industrial production of paints and synthetic resins. Its parent company is H.B. Fuller which is based in the United States. According to the “Transfer Pricing Policy” set by the parent company and in place since 1992, a 10% margin on sales was applied to inventory transferred between affiliates. However, during the fiscal periods 2003 and 2004, the parent company changed the policy so that sales to related companies abroad were to be made with a profit margin of only 5%, while for local affiliates and independent parties, the margin would be 10%. The tax administration issued an assessment in which the margin of all the controlled transactions was set at 10% resulting in additional taxable income of ¢185,827,941.00. According to the tax administration the 5% margin was not even enough to cover the operating expenses for the transactions in question. Judgement of the Administrative Court The court ruled in favour of Reca Quimica due to formal grounds. However, the assessment was allowed to be issued again in accordance with the guidelines set out in the ruling. Excerpts “In the view of the Court of First Instance, we are therefore faced with conduct which, contrary to what the applicant’s representatives allege in arguing that the plea does not exist, is vitiated by a partially inadequate statement of reasons, but which does not give rise to the defects of absolute invalidity pointed out by the applicant’s representatives. “The Court considers that the plea does exist, since, as indicated above, the evidence adduced in the file, including the evidence admitted for the purpose of a better decision, which refers to the consolidated financial statements of the applicant company, provides the Court with the certainty that […] sold at prices below cost […], and that […] sold at prices below cost […]. …] sold at prices below the cost of sales to its related companies, in the fiscal periods two thousand three and two thousand four, incurring in a practice (sic) that derived in a self-determining action on the part of the plaintiff company in which it established as the amount of its tax obligation, an amount lower than the amount that would have corresponded in the case of applying the market value. This is the cause or reason for the contested conduct, and it is precisely the factual assumption that served as a background for the Administration to issue the contested acts. Thus, although it is wrong to state as part of the reasoning that the taxpayer’s accounts are irregular and contradictory, the fact is that it is also expressly stated, and implicitly found throughout the content of the various contested decisions, that the reason for the administration’s intervention, and its unofficial determination action, was precisely the fact that the taxpayer’s accounts were irregular and contradictory, and that the taxpayer’s accounts were irregular and contradictory, was precisely the fact that it was able to determine the existence of related operations that, by selling at prices below the cost of sales, caused damage to the Treasury by reducing the size of the tax obligation of the taxpayer, conduct that is due to tax planning, and for which the law offers a solution through sections 8 and 12 of the Tax Code, as we will see below.” “Consequently, it was not possible in this hypothesis to resort to the determination by the presumptive basis method, and the partial annulment claimed in this respect had to be upheld. Indeed, in the opinion of the undersigned, the ATGC should have proceeded by the method of certain basis, which, since we are in a transfer pricing scenario, implied carrying out the corresponding analysis based on the technical rules of the OECD, mentioned above, which was perfectly possible based on the theoretical and legal framework set out in Interpretative Guideline number 20-03, already in force at the time. Although in the complaint the plaintiff claims that the content and justification of the aforementioned Guideline is erroneous and even illegal, the fact is that it does not challenge it, so that there is no impediment in this respect, particularly in light of the related constitutional ruling.” “The legal situation of the plaintiff is restored to the date on which the first of the contested acts was issued, so that if it is legally appropriate, the Tax Administration may issue it again, in accordance with the guidelines set out in this ruling.” Click here for English translation Click here for other translation ...

Nestlé de Costa Rica S.A. had been issued a tax assessment in which the taxable income for FY 2005 and 2006 was adjusted with an additional amount of ¢60,609,096.00 and ¢75,663,084.00. According to the tax authorities, the sales made by Nestlé to its related companies located in Chile, Switzerland and Puerto Rico had a profit margin different from those made to third parties. The margin on the unrelated transactions was 88% whereas the margins on comparable related party transactions was only 7%. The adjustments was determined based on internal CUPs. Judgement of the Court The Court dismissed the appeal of Nestlé. Excerpts “This Chamber agrees with the Tribunal, in the sense that the expert witness Luna Ramírez, during her testimony, does not manage to disprove the system applied by the Tax Administration, since she rejects the method used, however, she also states that it is difficult to resort to any other method. What is clear from this testimony is that in this process the plaintiff could not substantiate or justify the reason why it sold the same product at a lower price to its related companies.” “According to the study made by the Tax Administration, which again was not contested by the plaintiff, the average profit on the standard cost of the products sold to independent companies was 87.87%, while with the related companies it was 7.17% for the tax periods at issue here. The difference is so large that it is not possible to explain reliably the reason for this disparity.” “Therefore, this Chamber endorses the Court’s position of upholding the criterion issued by the Tax Administration and collecting the differences due to the total non-payment of the tax.” Click here for English translation Click here for other translation ...

The Tax Court of Canada upheld the right of Avotus Corporation to deduct from its Canadian income losses incurred by its subsidiary in Puerto Rico. The Tax Court found that the Puerto Rican subsidiary was Avotus’s agent under a validly executed agency agreement, rejecting the CRA’s claim that the written agreement was unacceptable because the subsidiary’s conduct was inconsistent with that of an agent ...

In this case a pharmaceutical company in the US, Eli Lilly & Co, transferred valuable pharmaceutical patents and manufacturing know-how to its subsidiary in Puerto Rico. The IRS argued that the transaction should be disregarded (substance over form) and claimed that all of the income from the transferred intangibles should be allocated to the U.S. parent. The Judgment from the Tax Court: “Respondent’s argument, that petitioner, having originally developed the patents and know-how, is forever required to report the income from those intangibles, is without merit. Respondent ignores the fact that petitioner, as developer and owner of the intangible property, was free to and did transfer the property to the Puerto Ricanaffiliate in 1966.” The Court of Appeals altered the judgement from the Tax Court. According to the Court of Appeals, the parent company had received an arm’s length consideration for the transfer of intangibles in the form of stock in the subsidiary. Hence, the Court disallowed the allocation of the intangibles’ income to the U.S. parent ...

During the years in issue, 1975 through 1981, the worldwide operations of Perkin-Elmer (P-E) and its subsidiaries were organized into five operating groups, each of which was responsible for the research, manufacturing, sales, and servicing of its products. The five product areas were analytical instruments, optical systems, computer systems, flame spray equipment and materials, and military avionics. P-E and PECC entered into a General Licensing Agreement dated as of October 1, 1970, by the terms of which P-E granted PECC an exclusive right to manufacture in Puerto Rico and a nonexclusive right to use and sell worldwide the instruments and accessories to be identified in specific licenses. P-E also agreed to furnish PECC with all design and manufacturing information, including any then still to be developed, associated with any licensed products. PECC agreed to pay royalties on the products based upon the “Net Sales Price”, defined as “the net amount billed and payable for *** [licensed products] excluding import duties, insurance, transportation costs, taxes which are separately billed and normal trade discounts.” In practice, P-E and PECC interpreted this definition to mean the amount PECC billed P-E rather than the amount P-E billed upon resale. The specified term of this agreement was until the expiration of the last license entered into pursuant to the agreement. Following an audit the tax authorities issued an assessment of additional income taxes related to controlled transactions between the above parties. The issues presently before the Tax Court for decision were: [1) Whether the tax authorities’s allocations of gross income to P-E under section 482 were arbitrary, capricious, or unreasonable; (2) whether the prices FE paid for finished products to a wholly owned subsidiary operating in Puerto Rico were arm’s-length amounts; (3) whether the prices the subsidiary paid to P-E for parts that went into the finished products were arm’s-length amounts; (4) whether the royalties the subsidiary paid to P-E on sales of the finished products to P-E were arm’s-length amounts; and (5) for prices or royalties that were not arm’s length, what the arm’s-length amounts are ...