August was an exciting month for those who follow U.S. transfer pricing litigation. Courts handed down opinions in the high-stakes, long-running Medtronic
Inc. v. Commissioner and Eaton v. Commissioner cases.
Although it is too soon to predict the long-term consequences of each opinion, for now both represent at least a partial loss for the IRS.
The first case, Medtronic, has been going since 2011, when the implantable medical device manufacturer first filed its Tax Court petition contesting over $1.3 billion in deficiencies assessed by the IRS for the 2005 and 2006 tax years.
The Tax Court’s first opinion in the case, issued in 2016, sided with Medtronic on one of the most contentious and common issues in transfer pricing: whether the royalty an offshore subsidiary owes its U.S. parent for intangible property rights should be priced using a transactional comparable (the comparable uncontrolled transaction method) or by calculating a fixed return for the subsidiary and treating the residual profit as the royalty (the comparable profits method). In Medtronic and related cases, the CUT method is the taxpayer’s method of choice while the IRS favors the CPM.
After a successful IRS appeal to the Eighth Circuit and a second trial on remand in 2021, the Tax Court’s August opinion rejected both parties’ methods.
Although the outcome was more favorable in dollar terms for the IRS than it was in 2016, it still dealt a blow to the agency’s campaign to gain greater judicial acceptance of the CPM — a campaign that saw its first major victory in the Tax Court’s 2020 Coca-Cola v. Commissioner opinion.
The Eaton case concerns the IRS’s discretion to cancel an advance pricing agreement, which is a contract between the agency and a taxpayer concerning the proper transfer pricing method and the way in which it should be applied.
The IRS rarely attempts to cancel an APA, but it did so in Eaton because of a series of compliance and reporting errors that were inadvertent and self-reported but significant in magnitude.
In August the Sixth Circuit affirmed the Tax Court’s 2017 ruling that the IRS’s cancellation decision was an abuse of discretion because Eaton’s errors didn’t satisfy the materiality standard set by the relevant IRS revenue procedure.
The IRS outright lost its appeal in Eaton, and the outcome in Medtronic was closer to a loss than a win. This arguably breaks what some considered to be a rare winning streak for the IRS in transfer pricing cases, an area in which the agency has historically struggled in litigation.
The IRS successfully appealed the first Medtronic opinion in 2018, leading the Eighth Circuit to remand the case to the Tax Court. In 2019 the IRS won a major victory in its appeal of Altera v. Commissioner and received an encouraging consolation prize in its unsuccessful Amazon v. Commissioner appeal, in which the Ninth Circuit observed that the IRS would have won under current law. And in arguably its greatest win, the IRS persuaded the Tax Court to uphold its CPM analysis in the 2020 Coca-Cola v. Commissioner opinion.
Does this mean the IRS’s short-lived winning streak is at an end? Not necessarily.
The Medtronic saga may not be over yet. The Tax Court’s second opinion endorsed a highly unusual transfer pricing method that may be vulnerable in a new appeal, and the appeal window remains open to the government.
It’s hard to predict how the Eighth Circuit would decide the case, but there is no reason to rule out the possibility that a second appeal would succeed.
And Eaton involves a narrow question that rarely arises. Neither taxpayers nor the IRS typically invest substantial time and resources negotiating an APA only to cancel it after it goes into effect. And the case was decided based on the text of a revenue procedure that was superseded years ago.
The IRS is working on another updated revenue procedure governing APAs, and it would take little more than a few minor word changes to give the agency the upper hand in any future Eaton-like cases.
It may well be that the IRS’s brief run of successes is about to draw to a close, but it’s also possible that a successful second Medtronic appeal and a stricter APA revenue procedure will reinforce the agency’s position.
Until then, it would be premature to declare a return to the days of IRS futility in transfer pricing cases.