In a decision that could affect billions of dollars in back taxes, a federal appeals court has tossed out a U.S. Tax Court ruling that found in favor of Medtronic, saying that the lower court failed to analyze several critical factors.
The court decision applies directly to more than $1 billion worth of tax deficiencies in 2005 and 2006, but a final resolution of the case is likely to impact billions more in disputed taxes that have accumulated from 2007 on.
The dispute involves the taxes owed on pacemakers, implantable defibrillators and leads manufactured at Medtronic factories in Puerto Rico in 2005 and 2006. Medtronic's internal accounting had placed most of the tax liability for those products on plants on the U.S. territory, but the Internal Revenue Service called that accounting a "classic case" of a multinational corporation shifting income on paper to avoid paying U.S. taxes.
The IRS eventually determined that Medtronic owed roughly $1.4 billion to the U.S. to settle the tax disputes related to those products. But following litigation, a judge in U.S. Tax Court sided with Medtronic, finding that the company owed $26 million for 2005, and had actually overpaid by $12 million in 2006.
On Thursday, a three-judge panel of the Eighth Circuit U.S. Court of Appeals ruled that the Tax Court failed to consider several important technical legal factors in its analysis of Medtronic's transfer tax situation. As a result, the panel vacated the ruling and sent the case back to the Tax Court.
A Medtronic spokesman noted that the federal appeals court remanded the case back to Tax Court for additional factual findings on several specific issues.
"It is important to note that this is a procedural decision and not a ruling on the merits," Medtronic spokesman Jeffrey Trauring said via e-mail. "The Eighth Circuit determined that it needed additional analysis from the Tax Court before it could rule on the merits of the appeal, which could now take years to finally determine. We still believe our initially filed tax returns were correct and will continue to defend our position."
The appeals court judges wrote that the Tax Court failed to consider: the complex circumstances surrounding another tax-accounting agreement known as the "Pacesetter agreement," which was used as a comparable example of an arms-length transaction; the value of "cross-licenses" and intangible items related to the Medtronic products made in Puerto Rico; and the specific amount of risk and liability that the Puerto Rico plants actually bore in return for their share of the profits on paper.
Medtronic had argued that its Puerto Rico subsidiary "bears the lion's share of potential liability" for any of its defectively made products, which meant that it was also entitled to a "commensurate rate of return" on its operations, the circuit judges wrote, summarizing the arguments in Tax Court.
Although it's not reflected in public securities filings, Medtronic attorneys showed during a seven-week trial in Tax Court that the company's Puerto Rico manufacturing operations did ultimately bear the financial liability when hundreds of thousands of Sprint Fidelis defibrillator leads were recalled over product defects in 2007.
The IRS has called Medtronic's tax accounting for Puerto Rico a "classic case of a U.S. multinational taxpayer shifting income from its highly profitable U.S. operations and intangibles to an offshore subsidiary operating in a tax haven, by charging an artificially low rate for the intangibles."
The dispute centers on a process known as "transfer pricing," which involves estimating the true value of intangible assets like trade secrets and regulatory approvals. Transfer pricing is an important issue at many multinational companies that hold valuable intellectual property, because it helps determine how much profit can be taxed in low-tax countries. Heart-device manufacturers Boston Scientific Corp. and St. Jude Medical have also had transfer-pricing disputes with the IRS over the years, for example.
In its original tax returns, Medtronic lowered its taxes owed on Puerto Rico-made heart devices in the U.S. by accounting for some of the profits in Puerto Rico, court filings show. The IRS says Medtronic's factories in Puerto Rico should have been paying more in royalties to the parent company, which then could have been taxed in the U.S.
The decision could have much broader implications beyond two tax years. The Eighth Circuit decision only involves Medtronic's 2005 and 2006 taxes, but securities filings show Medtronic has similar pending tax disputes from 2007 on.
In a concurring opinion with the 3-0 decision Thursday, U.S. Circuit Judge Bobby Shepherd noted that when such cases are litigated, federal guidelines require that specific factors like the value of intangibles, allocation of legal risk and truly comparable arms-length transactions be considered before the court can rule on a complex tax case like Medtronic's.
"Simply put, the Treasury Department and courts in [other types of] cases deem these factors significant," Shepherd wrote. "At the very least, the taxpayer deserves an explanation why they are insignificant in this case."