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Tax Cuts and Jobs Act Could Breathe New Life into Transfer Claim Implicit Intangibles




At the end of the 2016 Tax Court opinion in Medtronic, a short section briefly summarizes and summarily rejects what the opinion describes as the “IRS alternative allocation under section 367(d)”. A similar superficial assessment is hidden in the 2017 Tax Court opinion in Eaton, which rejects substantially the same alternative argument for the same reasons, often using almost exactly the same language. This alternative argument, according to which the taxpayer's acceptance of the transfer pricing method implies that there must have been an intangible transfer subject to section 367(d), has received relatively little attention. This likely reflects the IRS's failure to date to successfully present the argument, the agency's decision to prioritize its section 482 position, and the absence of the alternative argument in the government's Medtronic and Eaton appellate briefs. However, its skeptical reception at Medtronic, TC Memo. 2016-112, and Eaton, TC Memorandum. 2017-147, does not condemn the argument to perpetual irrelevance, especially for disputes involving tax years subject to the Tax Cuts and Jobs Act. As long as the low-tax subsidiary can be used as the tested party, CPM is the natural method of choice for the IRS in this scenario because it restricts the amount of earnings that can be allocated offshore.


After assigning some fixed return to the analyzed party as a percentage of sales, costs, or assets, CPM assigns all residual returns to the other party by default. Pricing the license of valuable intangible assets from a U.S. parent company to a low-tax foreign subsidiary using the CPM and using the subsidiary as the tested party avoids assigning any residual intangible-related returns to the parent company. low tax jurisdiction. US-based multinationals like Medtronic and Eaton, with low-tax subsidiaries, naturally tend to prefer other methods, especially the comparable uncontrolled transaction method, which can offer their subsidiaries a portion of residual returns. Alleging failures in the IRS's selection of the examined party often plays a key role in taxpayers' attempts to downgrade the reliability of the CPM relative to the CUT method. As stated in reg. section 1.482-5(b)(2)(i) , “in most cases, the tested party will be the least complex of the controlled taxpayers and will not possess valuable intangible property or unique assets that distinguish it from possible uncontrolled comparables ”. Consequently, taxpayers involved in these types of disputes often argue that their low-tax foreign subsidiary's ownership of unique and valuable intangibles disqualifies their selection as the tested party and, as a result, makes the CPM unreliable. Although the IRS devotes most of its efforts in these disputes to defending its selection of the CPM by challenging taxpayer inflated characterizations of its tax-favored subsidiaries, the IRS section 367(d) alternative argument turns those characterizations against it. of the taxpayer.


If the foreign subsidiary, which in Medtronic and Eaton did not own significant self-developed intangibles, is too complex to be the tested party in a CPM analysis, then it must have acquired the necessary intangibles to justify its high returns at some point, the argument he. At Medtronic, that moment was when the two US subsidiaries that oversaw the group's Puerto Rican manufacturing operations until 2001 exchanged substantially all of their assets for shares in Medtronic Puerto Rico Operations Co. (MPROC) in a section 351 exchange. The IRS explained its implied theory of intangible transfer as applied to Medtronic in a June 2016 Amended Second Opening Brief filed with the Tax Court, in which the agency argued that the unequal allocation of profits among U.S. entities of Medtronic and MPROC implied that the 2001 section 351 exchange must have involved an outward transfer of intangible property. Invoking section 367(d) , which mirrors the section 482 regulations in key respects, the IRS argued that US transferors should be treated as if they had sold the transferred intangible property for royalty payments during the course of the transaction. useful life of intangible property. “Respondent's primary position is that Petitioner's transfer pricing under section 482 was not at arm's length. If the tribunal were to treat petitioner's transfer pricing at arm's length and conclude that MPROC is entitled to nearly two-thirds of the profits from the [heart rhythm disease management] and [implantable neurological device] businesses, then it is a fact that the value of the newly formed MPROC did not appear out of nowhere, but had to be the result of a massive infusion of intangible assets at its inception,” the brief says. "Under this alternative position, section 367(d) requires inclusions of income attributable to the outward transfer of intangible assets transferred by a US transferor."



In presenting its alternative section 367(d) argument in the 2016 report, the IRS highlighted the biased earnings allocation caused by Medtronic's CUT method analysis rather than the reliability of the method under the section 482 regulations. Regardless, the implication is that MPROC had no realistic way of acquiring the kind of intangibles that would disqualify its selection as the tested party in a CPM analysis unless it had been the transferee of high-value intangibles. The corporate reorganization that established MPROC, the licensee in the transaction at the center of the case, as the entity responsible for all of Medtronic's manufacturing operations in Puerto Rico was a logical place for the IRS to look for that transfer. It would be an exaggeration to suggest that there is an unbreakable link between intangible property as it relates to the selection of the analyzed part under reg. section 1482-5 and the existence of an intangible transfer subject to section 367(d) . Ownership of intangibles is significant under the CPM because it presents a practical problem of comparability, and there is no reason to assume that "valuable intangible property or unique assets" referred to in reg. section 1.482-5(b)(2)(i) are aligned with the definition of “intangible property” for purposes of section 367(d) . The specific reference in the CPM regulations to “unique assets” casts particular doubt on any assumption, as it suggests that items other than “intangible assets” may disqualify the owner of the selection as a tested party.


However, these technical distinctions do not fundamentally undermine the logic of the IRS's implicit pass-through argument. Although his motion was denied, the IRS highlighted that logic when it requested permission to file an amended response during Medtronic's second lawsuit. The IRS contrasted Medtronic's expert witness testimony, which suggested that MPROC's high returns were attributable to its ownership of unique manufacturing know-how, with the terms of the MPROC license and Medtronic's earlier assertion that no transfer of assets covered by section 367(d) never took place “We have not seen any explanation of how that [ownership] occurred, and it appears highly inconsistent with Petitioner's statement in his brief at the first trial that MPROC had no intangible assets, and there were no intangible assets for which other intangibles: good will, running. the value of concern and on-site labor could be attached,” argued Jill Frisch of the IRS Office of General Counsel during the second trial. “Under petitioner's intercompany license, all know-how is owned by Medtronic Inc.”

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