# United **States Tax Court**

T.C. Memo. 2022

- 84

MEDTRONIC, INC. AND CONSOLIDATED SUBSIDIARIES

, Petitioner

v

. COMMISSIONER OF INTERNAL REVENUE, Respondent 1

—————

Docket N o. 6944

- 11. Filed August 1 8 , 2022.

—————

Andrew D. Allen

, David J. Berke

, Melinda Gammello

, Thomas V. Linguanti

, Rajiv Madan

, and Jaclyn M. Roeing

, for petitioner.

John Edward Budde

, Paul L. Darcy

, Laurie B. Downs

, Elizabeth P.
Flores

, Jill A. Frisch

, Jeannette D. Pappas

, and H. Barton Thomas

, for respondent.

SUPPLEMENTAL MEMORANDUM
FINDINGS OF FAC T AND OPINION

KERRIGAN

, Chief Judge : This matter is before the Court on remand from the U.S. Court of Appeals for the Eighth Circuit for further consideration consistent with its opinion in Medtro nic II , 900 F.3d 610

. The Eighth Circuit remanded the case for further consideration in the light of the views set forth in its opinion. See id. at 615. The Eighth
Circuit stated: “ T he [T]ax [C]ourt determined that the Pacesetter
agreement was an approp riate [comparable uncontrolled transaction (CUT) ] because it involved similar intangible property and had similar circumstances regarding licensing. We conclude that the [T]ax [C]ourt’s

1 This Opinion supplements our previous Opinion Medtronic, Inc. & Consol.
Subs. v. Commissioner ( Medtronic I ), T.C. Memo. 2016

- 112, vacated and remanded

, Medtronic, Inc. & Consol. Subs. v. Commissioner ( Medtronic II ), 900 F.3d 610 (8th Cir. 2018).



### Served 08/18/222

[* 2 ] factual findings are insufficient to enable us to conduct an
evaluation of that determination

. ” Id . at 614

.

The Eighth Circuit stated that we did not provide (1) sufficient
detail as to whether the circumstances between S ie m e ns Pacesetter , Inc. (Pacesett er)

, 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 M PROC licensing agreement; and (4) the amount of risk and product liability expense that should be allocated between Medtronic US and
MPROC

. See id. at 614

– 15. The Eighth Circuit “deem[s] such findings
to be essential to [its] review of the [T]ax [C]ourt’s determination that
the Pacesette r agreement was a CUT, as well as necessary to [its] determination whether the [T]ax [C]ourt applied the best transfer pricing method for calculating an arm’s l ength result or whether it made proper adjustments under its chosen method.” Id. at 615.

The p arties agreed that the record did not need to be reopened with respect to the amount of risk and product liability expense that
should be allocated between Medtronic US and MPROC because the record is already sufficient to make additional factual findings on that
issue. Pursuant to the Court ’s May 3, 2019, Order

, further trial was scheduled for expert testimony to address:

(1) whether the Pacesetter agreement is a CUT ;

(2) whether this Court made appropriate adjustments to the Pacesetter agreement as a CUT ;

(3) whether the circumstances between Pacesetter and Medtronic US were comparable to the licensing agreement between Medtronic and [ MPROC ] and whether the Pacesetter agreement was an agreement created in the ordinary course of business;

(4) an analysi s of the degree of comparability of the Pacesetter agreement’s contractual terms and those of
the [ MPROC ] licensing agreement;3

(5) an evaluation of how the different intangibles affected the comparability of the Pacesetter agreement and the [ MPROC ] licensing agreement;

(6) an analysis that contrasts and compares the CUT method using the Pacesetter agreement with or without adjustments and the [comparable profits method (CPM) ] , including which method is the best method.

See Medtronic II

, 900 F. 3d at 614

– 15.

Respondent determined deficiencies as amended by Answer in petitioner’s federal income tax of $548,180,115 and $810,301,695 for 2005 and 2006 (years in issue), respectively. Unless otherwise indicated, all statutory references are to the Inte rnal Revenue Code,
Title 26 U.S.C. (Code) , in effect at all relevant times, all regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and all Rule references are to the Tax
Court Rules of Pra ctice and Procedure. We round all monetary amounts
to the nearest dollar.

We held in Medtronic I that the CUT method was the best method for determining the arm’s

- length rate. Medtronic I

, at *138. We concluded that a reasonable wholesale royalty rate for the devices is 44%, a reasonable wholesale royalty rate for the leads is 22%, and the wholesale royalty rate for devices should be 44% for the Swiss supply
agreement. Id. at *137

– 39.

The issues for our consideration are (1) whether the CUT method
is the best method for determining the arm’s

- length rate, (2) what the proper royalty rates are for the devices and the leads, and (3) what the proper royalty rate is for devices sold pursuant to the Swiss supply
agreement.

After analyzing the above issues, w e conclude that petitioner has

not met its burden to show that its allocation under the CUT method and its proposed unspecified method satisfy the arm ’s

- length standard. We further conclude that respondent ’s modified CPM results in an abuse
of discretion and that the wholesale royalty rate for devices and lea ds is 48.8%. Accordingly, the wholesale royalty rate for devices cover ed b y the Swiss Supply Agreement is 48.8%. [* 3 ]4

[* 4 ] FINDINGS OF FACT

On January 22, 2015, the Court issued a protective order which has been amended and extended to prevent the disclosure of petitioner’s proprietary and confidential information. The facts and opinion have been adapted accordingly, and any information set forth herein is not proprietary or confidential.

Medtroni c US is a Minnesota corporation with its principal place of business in Minneapolis, Minnesota. During 2005 and 2006 Medtronic US was the parent corporation of a group of consolidated corporations and multinational affiliated subsidiaries (collectively,

p etitioner).

Facts of this case were found in our original O pinion, Medtronic I

, and are incorporated by this reference. We summarize, clarify, and add to the facts to address the holding in Medtronic II

.

I. Overview of Petitioner

Since the early 1960s petitioner has been a leading medical technology company with operations and sales worldwide. By 2005 petitioner operated in more than 120 countries and had approximately 33,000 employees worldwide. During 2005 and 2006 petitioner o perated through multiple business units; this case, however, involves only the Cardiac Rhythm Disease Management (CRDM) and Neurological (Neuro) business units. During the years in issue CRDM had more employees and substantially more revenue than Neuro. Both business
units had devices and leads that are at issue in this case. The device operations across both business units were larger and earned more revenues than the leads operations. Medtronic maintained its operations in Puerto Rico through MPROC.

A

. Medtronic Puerto R ico

MPROC has been manufacturing class III implantable medical devices for sale in the United States and around the world for nearly 50 years. For the past almost 20 years, it has been conducting its operations under licenses from its parent, Medtronic US.

MPROC manufactures devices and leads, both of which are life

saving or life

- sustaining class III medical devices, as defined and determined by the Food and Drug Administration (FDA). Medtronic US and MPROC entered into license agre ements under which MPROC5

[* 5 ] obtained the right to use, develop, and enjoy the intangible property for manufacturing devices for sale to customers in the United States and its territories and possessions and leads for sale to customers worldwide

.

MPROC’s device and leads operations were FDA

- registered facilities subject to regular pre

- market and post

- market inspection by the FDA, as well as by international regulatory agencies, and were solely responsible for manufacturing the products ultimately implante d in patients. MPROC was involved in every aspect of the manufacturing processes for devices and leads. It was solely responsible for ensuring that the final manufactured devices and leads met the required specifications and for determining whether a dev ice or lead met the applicable regulatory standards and whether it was ready for implantation in the human body. MPROC had the responsibility of inspecting and handling the finished devices or leads and ensuring that all components were properly combined so that the device could provide the patient therapy repeatedly and reliably.

The process to make devices and leads was very detailed. It required skilled workers. MPROC would fire an employee if a defect could be traced back to that employee’s work, ev en if it was the employee’s first mistake. MPROC tested and sterilized finished devices and leads. As Medtronic’s senior vice president of medicine and technology testified convincingly : “You can have all the essentially great parts you want, but the cri tical stuff is in the systems engineering. Those things put it together and manufacture it reliably at scale. It’s crucial. You don’t do that you have no product.”

The manufacturing processes for both devices and leads takes a week or longer. The prod ucts are made in an FDA

- regulated “cleanroom” environment. Some processes cannot be done automatically and require skilled workers to complete them by hand.

MPROC was not only concerned with being able to produce products at a high volume, it was also concerned that each product be made with the highest quality and be able to be placed inside a patient. It was difficult to manufacture sensitive medical equipm ent at a high volume and maintain quality. MPROC employees would participate in core teams where they would partner with Medtronic US through each development phase of new products to ensure that newly developed products were manufacturable at commercial scale. The bottom line
was that if a finished product cannot be made, it cannot be sold.6

B. Med USA

Med USA is a Minnesota corporation with its principal place of business in Minneapolis, Minnesota. Med USA was a member of
Medtronic US’s consolidated group. During 2005 and 2006 MPROC sold
devices and leads to Med USA for sale in the U nited S tates and other jurisdictions. Med USA’s CRDM and Neuro sales organizations were responsible for building relationships with and selling products to

customers

, including physicians; developing their respective markets by educating physicians and patients; delivering products to customers for use in surgery; and providing assistance to physicians and patients before, during, and after surgery. Med USA’ s sales representatives were not medical professionals; rather, they played a support role in surgery by providing technical support for devices and leads to implanting physicians as needed.

During the years in issue the CRDM sales organization consisted of approximately 2,000 sales representatives

, and the Neuro sales organization consisted of approximately 200 to 300 sales representatives. Sales staff received base pay and commissions.

C. Class III Medical Devices

In order for certain medical devices t o be legally marketed in the United States, they must be FDA approved. The FDA requires all
manufacturers of medical devices distributed in the United States to register their facilities, list their medical devices, and follow certain requirements. The F DA classifies medical devices according to the risks that they pose to consumers. The Medical Device Amendments of 1976 to the Federal Food, Drug, and Cosmetic Act classified medical devices
that were on the market at the time into one of three classes: c lass I, class II, and class III. Medical Device Amendments of 1976, Pub. L. No.

94

- 295, § 2 , 90 Stat. 539, 540 (codified as amended at 21 U.S.C. 360c)

. Class I medical devices are subject to the fewest regulatory controls, and
class III medical devices a re subject to the most stringent controls. Class III medical devices must comply with certain controls and go through a premarket approval (PMA) process. The PMA process is lengthy and
can often take five to ten years. Class III medical devices are high er risk
and more novel than are those of classes I and II.

Medical devices are categorized as class III if there is insufficient information that existing controls applicable to classes I and II devices are sufficient to provide reasonable assurance of sa fety and effectiveness [* 6 ]7

[* 7 ] and the devices are “purported or represented to be for a use in supporting or sustaining human life or for a use which is of substantial importance in preventing impairment of human health.” 21 U.S.C. 360c(a)(1)(A)(ii)(II) . Class III medical devices req uire more scrutiny
than class I or class II devices. Class III medical devices include those
which are life supporting or life sustaining, such as implanted cerebellar stimulators, heart valves, and certain dental implants. Examples of
class I medical de vices are elastic bandages and examination gloves. Examples of class II medical devices are powered wheelchairs and infusion pumps.

Class III medical devices must typically be FDA approved before they are marketed through the PMA process, which is rigoro us, costly, and time consuming. The PMA requires a demonstration that the new medical device is safe and effective. That demonstration is performed by collecting data, including human clinical data, for the medical device.

The class III medical devices primarily at issue in this case are devices and leads. The devices and leads are developed, manufactured, marketed, and sold through Medtronic’s CRDM and Neuro business segments, which are described in greater detail below.

D. CRDM and Neuro Business Unit s

1. CRDM

During 2005 and 2006 Medtronic’s CRDM unit was the world’s leading seller of cardiac rhythm stimulation devices. Medtronic’s CRDM business focused on managing the entire spectrum of cardiac rhythm disorders to improve long

- term patient care thr ough products that restore and regulate a patient’s heart rhythm and improve the heart’s pumping function. Its products were devices, leads, and the associated delivery systems for the devices.

a. Manufacturing

In general cardio devices have three primar y components: implantable pulse generators (IPGs), leads, and programmers. IPGs are battery

- powered computer

- based devices that continually monitor the heart, analyze cardiac signals, and apply therapeutic actions based on their programming algorithms. L eads are flexible sets of wire that
connect the IPGs to the heart. Leads connect at one end to the heart and at the other end to the IPG. Programmers are external devices that communicate through the skin to the IPG to obtain information from the8

[* 8 ] IPG regarding its activities. Programmers were manufactured by
an outside vendor and are not relevant to this case.

b. Devices

CRDM device products consisted primarily of bradycardia pacemakers, also known as IPGs; tachyarrhythmia (tachy) devices, also known as implantable cardioverter defibrillators (ICDs); and cardiac resynchronization therapy (CRT) devices. IPGs treat abnormal ly slow heart rates. ICDs treat abnormally fast heart rates. ICDs also have capacitors as component s . CRTs treat insufficient blood flow and uncoordinated pumping of the heart’s chambers.

During 2005 and 2006 the device operations at MPROC built

more t han 40 different models of devices and approximately 250,000 to 280,000 devices per year; it was the primary or sole manufacturer of
most models of devices sold in the U nited S tates

. The 40 different models of devices comprised approximately 750 individua l components.

MPROC’s device operations made complex pieces of electronic machinery that are extremely difficult to manufacture. The process was labor and capital intensive and time consuming and required numerous quality checks. Manufacturing a device was a multistep process that involved approximately 40 steps. Depending on the complexity of the particular device, manufacturing could take 7 to 14 days to build a single
device.

While the device operations used automated processes to
manufacture device s, MPROC relied on its employees to verify those automated processes, to perform multiple quality inspections throughout each manufacturing stage, to complete significant portions of the process manually, and to oversee and troubleshoot all manufacturing p rocesses generally. Highly trained and skilled operators oversaw all manufacturing processes.

MPROC needed to use extreme care to interconnect the various components of a device, ensure that it was hermetically sealed, and
sterilize it . With regard to t he interconnect welding step of the device manufacturing process, for example, operators had to painstakingly inspect the welding that took place at each and every preceding step of the device manufacturing process for any discoloration or damage.
Because of the stringent quality standards that class III finished devices must meet, the device operations maintained a detailed traceability system of each step of the manufacturing process in the event that it9

[* 9 ] needed to trace a quality issue to its source in the manufacturing

process.

c. Leads

CRDM products included leads, which are highly complex “wiring” systems that connect devices to the human body and deliver therapies. Leads are the devices that transmit therapies from a device
to the heart via electrical signals and information about the heart’s activity from the heart to the device. Leads are thin wires that are insulated with silicone or polyurethane and are implanted into the right atrium, right ventricle, or left ventricle of the heart.

Be cause CRDM leads are implanted in a patient’s heart, removing a lead because of a product quality defect can be an extremely difficult procedure. After implant, fibrous tissue forms around the lead, around the nearby blood vessels, and within the heart. Leads were not designed to be extracted from the human body. When a product quality problem occurs, the physician and the patient must determine whether to leave the lead in the patient’s body or, if the severity of the problem requires it, or the patient demands it, to remove the lead through an “extraction” procedure. In the case of CRDM leads, an extraction was
the riskiest procedure an electrophysiologist could perform on a patient. On average, there was a 1% chance that during an extraction, the

pro cedure would tear a major vessel or create a hole in the patient’s heart, which can be fatal.

2. Neuro

Medtronic’s Neuro business included implantable neurostimulation devices (neuro devices) and leads that deliver ed
electrical stimulation from neuro devi ces to the spinal cord, nervous system, or brain. The devices and leads delivered drugs or electrical stimulation to the spinal cord, brain, or other parts of the nervous system to treat pain, movement disorders, and other disorders, including Parkinson’s disease, essential tremor, chronic pain, and spasticity. Neuro devices included battery

- operated generators; leads that connect the generators to the spinal cord, brain, or nervous system; and programmers to communicate with the generators or recharge th e batteries.

Neuro’s products were often used to treat chronic back and leg pain, complex regional pain, and neuropathy through spinal cord stimulation therapy. In spinal cord stimulation therapy, neuro leads10

[* 10 ] are attached to specific parts of the sp inal cord. The therapy functions by blocking pain messages to the brain with electrical impulses to the epidural space near the spinal cord.

Neuro’s products used in deep brain stimulation safely and effectively manage some of the most disabling movement disorders, such as Parkinson’s disease, essential tremor, and dystonia. Leads are placed in targeted areas of the brain, and the amount of electrical stimulation is adjusted to meet the patient’s needs. Neurosurgeons, neurologists, pain management speci alists, and orthopedic spine surgeons commonly use these products.

a. Manufacturing

The manufacturing process for Neuro’s devices and leads was similar to the process for CRDM. Changes in the processes were due to different specifications of the products

.

b. Devices

Neuro’s devices were made in the Juncos facility in Puerto Rico. The process was very similar to the process for CRDM’s devices, but the specifications and applications of Neuro’s devices were different from
those of CRDM’s devices.

c. Leads

The producti on of leads was extremely complicated and labor intensive. Leads manufacturing was an almost completely manual process, performed within tight tolerances, requiring skilled labor to join raw material with lasers and adhesives. It could take up to several weeks to manufacture a single lead, and there could be over 100 steps in the manufacturing process. Each manufacturing step began with a review of the quality of the work performed in the prior step. The manufacturing process for even the subassembly of a single portion of a lead, such as the outer assembly of the lead, comprised approximately 20 steps. In addition to interim quality reviews, there were as many as 50 quality tests throughout the leads manufacturing process, depending on the complexity o f the particular lead. The leads operations maintained a detailed traceability system of each step of the manufacturing process in the event that it needed to trace a quality
issue back to its source.11

[* 11 ] MPROC’s leads operations were responsible for sp ecifying, purchasing, validating, and installing the equipment that it needed to manufacture leads. Neuro leads did not use any components from the
Medtronic Microelectronics Center or the Medtronic Energy & Component Center. Some equipment used in manufa cturing leads was custom designed to specifications established by the leads operations and built specifically for the leads operations. New equipment was subject to testing and required approval, not only from Medtronic, but
also from the FDA and other r egulatory agencies, before the equipment could be used in the manufacturing process.

E. Competitors

CRDM’s primary competitors were Guidant Corp. (Guidant), Boston Scientific Corp. (Boston Scientific) (after acquiring Guidant), and
St. Jude Medical, Inc. (St. Jude). From the late 1990s through 2005 and 2006 the CRDM market was dominated by Medtronic, and then Guidant and St. Jude, with only minor other players. Neuro’s primary competitors were Johnson & Johnson, Boston Scientific, Advanced

N euromodulation Systems, Inc. (Advanced Neuro), St. Jude (after its acquisition of Advanced Neuro) and Stryker Corp

. (Stryker) . Medtronic had the largest share of the U.S. market for neuro spinal cord stimulators and had no competitors in the U nited S tates for neuro deep
brain stimulators.

F. Self Insurance

The threats of class

- action lawsuits or multidistrict proceedings are frequent consequences of product recalls in the medical device industry. The type of insurance coverage that Medtronic needed to insure itself fully against its product liability risk, namely “catastrophic insurance” on the order of billions of dollars, was not available in the marketplace during the years in issue. Since 2002 Medtronic has been unable to obtain product liability insurance to insure against losses at commercially accept able premium amounts.

Thus, Medtronic self

- insured against product liability risk, effective May 1, 2002, as well as during 2005 and 2006. The decision to
self

- insure increased the level of scrutiny placed on quality. Once
Medtronic made the decision to self

- insure against product liability risk and no longer had any other kind of insurance to pay for losses associated with product quality, it was even more important that the finished product function properly.12

[* 12 ] Medtronic’s business and legal group s were responsible for identifying and resolving customer complaints regarding product problems as early as possible. Because Medtronic was self

- insured during 2005 and 2006, its claim management process was intended to minimize the risk of product liabil ity litigation.

II. MPROC Agreement

Medtronic US and Med USA entered into various agreements and amendments with MPROC that were effective during 2005 and 2006. Medtronic US and MPROC entered into license agreements, effective as of September 30, 2001, f or the intangible property used in manufacturing devices (devices license, as amended over the years) and leads (leads license, as amended over the years) (jointly, devices and leads licenses). The devices license was for products in the following
busines ses: bradycardia pacing, tachy management, and neurological stimulation. The leads license was for products that include medical therapy delivery devices, which include electrode leads for implantable pulse generators and implantable cardioverter defibri llators, and
neurostimulation electrode leads.

The MPROC agreement provided MPROC with an exclusive
license to use Medtronic US’ s patents and Medtronic US’ s portfolio of technology implantables. The total number of patents made available
to MPROC under t he MPROC agreement exceeded 1,600 by May 2004 and topped 1,800 through April 2006

.

Under the terms of the MPROC agreement, each party was required to disclose and share all know

- how and product improvements with the other. If terminated, the MPROC agreem ent barred MPROC from using or disclosing any confidential know

- how or other information received from Medtronic US for six years unless the information was public or was documented by MPROC before the agreement began

. The 2005 MPROC agreement had a one

- y ear term

, and the 2006 MPROC agreement had a three

- year term.

Under the devices and leads licenses, MPROC obtained the exclusive right to use, develop, and enjoy, not only Medtronic US’ s patents, but also the full array of intangible property necessary in manufacturing devices for sale to customers in the United States and its territories and possessions, and leads for sale to customers worldwide.

The devices and leads licenses both define intangible property for

any p roduct as:13

[* 13 ] Section 1. 4. Intang i ble Pr o pe rty

“In tangible Property ” shall mean Licensor developed inventions, secret processes, technical information, and technical expertise relating to the design of Product and all legal rights associated therewith, including without
limitation

, patents

, trade secrets, know

- how, copyrights
and a ll Regulatory Approvals associated with Pr o duct

.

As specified in the devices and leads agreements, intangible property included know

- how, which the agreements both defined as:

Section 1. 5. Kn ow

- How

“ Know

- How ” shall mean any and all technical info rm ation presently available or generated during the te rm of this Agreement that relates to Product or Improvements and shall include, without limitation, all manufacturing data and any other info rm ation relating to Product or Improvements and useful for the development, manufacture, or effectiveness of Product.

Under the devices and leads agreements, improvements consist of:

Section 1.3. Improvements

“ Improvements ” shall mean any findings, disc ov eries, inventions, additions, modifications

, formulations, or changes made by either Licensor or Licensee to product design during the term of this Agreement that relate to
Product

.

The device and leads licenses specifically include requirements about quality. Both agreements state:

Section 2.4. Quality

a. Product sold by Licensee shall meet the quality control standards and specifications established jointly by Licensor and Licensee, including any requirements of any applicable regulatory agencies.

b. In the event that quality control of Licensee falls below the agreed upon standards and specifications,14

Licensor shall give Licensee written notice of such failures, and Licensee shall, at its expense an d within a reasonable period set out in the notice, take such corrective action as is necessary to restore quality to the appropriate level.

The MPROC licenses assigned all product liability risk for devices and
leads to MPROC and stated that MPROC was “li able for all costs and damages arising from recalls and product defects.” MPROC took two main approaches to managing product liability. First, MPROC made every effort to ensure that its finished devices and leads were consistently manufactured to the hig hest standards in order to minimize the potential for product failures. Second, in the event of a lapse in product quality, the terms of the MPROC licenses dictated that MPROC was solely responsible for restoring product quality to agreed

- upon standards a nd bore all associated product liability costs.

In accordance with the devices and leads licenses, MPROC agreed to pay what Medtronic US and MPROC determined to be an arm’s

length wholesale royalty of 29% to Medtronic US on MPROC’s U.S. net intercompany s ales of devices and 15% to Medtronic US on MPROC’s net intercompany sales of leads. The initial terms of the device and leads licenses were through April 30, 2003. The MPROC agreements were renewable at both parties’ option and were renewed effective May 1, 2003 and 2004. The amendments effective May 1, 2003 and 2004, renewed the licenses through April 30, 2004 and 2005, respectively.

On May 22, 2007, Medtronic US and MPROC entered into amended and restated license agreements, effective May 1, 2005. Th e amendments were made to reflect agreements reached in a memorandum of understanding (MOU) between Medtronic US and the IRS. The amended agreements included a profit split methodology that changed the royalty rates. MPROC would pay a 44% wholesale royal ty rate to Medtronic US on its net intercompany sales of devices and a 26% wholesale royalty rate to Medtronic US on its net intercompany sales of leads. Other provisions of the licenses remained in place.

III. Pacesetter Agreement

In the late 1980s and early 1990s Medtronic US and Pacesetter were engaged in patent litigation related to Medtronic US’ s patents for many of its cardiac rhythm stimulation devices, including patents underlying its “Activitrax” technology, which established rate

- [* 14 ]15

[* 15 ] responsive pacemakers that monitor and adapt to changes in cardiac rhythm. To prevail in the dispute Medtronic US had to establish that its relevant CRDM patents were valid and that Pacesetter had infringed on one or more of them. Medtronic US was succes sful, and in late 1991 and early 1992, the district court ruled that (1) Medtronic US ’s Activitrax patent was valid; (2) Pacesetter was infringing on it; and (3) Pacesetter was permanently enjoined from selling three of its five

rate

- responsive CRDM produc ts.

A

. Background on CRDM Patents

The development of ICDs started around 1968. Dr. Mirowski was a pioneer in the field. His work resulted in implantable pacemakers. Dr. Mirowski’s work transformed the industry from high voltage external pacemakers to s ophisticated implantable device s that use multiple leads. He licensed two issued patents and a patent application to Medrad, Inc

. (Medrad), referred to as the Mirowski license, effective on January 30, 1973. The inventions covered by the Mirowski license were not proven until years after 1973

. In addition to a running royalty rate, Dr. Mirowski received an unknown amount of equity in Medrad

.

The Mirowski license is regarded as an important license in the CRDM industry. This license was important for gai ning market access. It was exclusively licensed to Eli Lilly and its subsidiary Cardia Pacemakers, Inc

. (CPI). Eli Lilly and CPI desired to maximize the
economic value of the Mirowski license.

The Mirowski license included patents for an elective intra

- atrial cardioverter, a semi

- implantable defibrillator, and an implantable
defibrillator. Eli Lilly and CPI entered into numerous license
agreements and the royalty rate remained 3% for approximately 30

years . In 1991 Medtronic entered into a cross

- licens e agreement with

E li Lilly and CPI that gave Medtronic access to the Mirowski patent portfolio in exchange for access to Medtronic’s Activitrax patent

. Medtronic licensed its patents to competitors, both before and after the
Pacesetter a greement.

B. Pacesetter Litigation Settlement

From fall 1991 through spring 1992 Medtronic US and Pacesetter reached a resolution of the lawsuits and negotiated the Pacesetter agreement and the settlement agreement. During that negotiation period, Medtronic US’s management analyzed potential settlement

te rms and presented that analysis to Medtronic US ’s board of directors.16

[* 16 ] After a tentative deal had been reached on May 26, 1992,
Medtronic US’ s senior vice president and general counsel presented the proposed terms to Medtronic US ’s board of directors, recommending that
Medtronic US accept the deal. Medtronic US projected that it would receive from Pacesetter total royalty payments of $200 to $300 million over the life of the agreement and that the value of the settlement in net present value (NPV) ter ms was expected to be $157 million. The NPV was increased to $200 million in a final analysis. According to petitioner, $17 million of litigation costs would be avoided by reaching a
settlement.

Medtronic US and Pacesetter finalized the terms of their

a greement in August 1992, and Medtronic US ’s board of directors approved it on August 26, 1992. The Pacesetter agreement settled nine
lawsuits and resulted in the dismissal of all litigation with prejudice.

The terms of the Pacesetter agreement were negotiated between competitors. Through the 1990s and 2000s the CRDM industry was dominated by three to five major companies , including Medtronic US

, Pacesetter, and later, St. Jude. At the time Medtronic US and Pacesetter negotiated the Pacesetter agreement, Siemens AG (Siemens), Pacesetter’s parent company, had worldwide revenue of approximately $50 billion, including medical revenue (pharmaceutical, capital equipment, and medical device revenue) of approximate ly $5 billion.

Siemens competed against Medtronic US as one of the largest medical device companies in the world, manufacturing and selling cardiac pacing products as well as other medical device products. Siemens operated its cardiac pacemaker business through Pacesetter. In its 1993 fiscal year Pacesett er controlled approximately 20% of the IPG market (the second largest market share at the time) and had revenues attributable to the sale of pacing devices of approximately $314 million. Pacesetter was expected to become a more significant player in
the t achy business by acquiring or developing its own tachy technology.

On March 3, 1992, Medtronic US prepared a comparative analysis of the potential value of continuing to litigate its patent infringement claims relative to settling on terms that would be

a cceptable to Medtronic US

. After settlement discussions had been initiated, in late April 1992, Pacesetter filed a countersuit alleging
Medtronic US ’s infringement of two of its patents by Medtronic US ’s pacemakers, Elite and Legend. That was the first t ime Pacesetter had
claimed Medtronic US infringed on its patents.17

[* 17 ] Medtronic US and Pacesetter finalized the terms of their agreement in August 1992. The financial terms of the finalized license
were more favorable to Medtronic US than those original ly presented in May 1992. In addition the finalized terms included a “Future Patent Provision,” which was added as Pacesetter’s other suits and counterclaims had previously related to unfair competition and
antitrust claims and Medtronic US ’s claims of in fringement. Medtronic
US ’s b oard of d irectors approved the settlement on August 26, 1992.

Those final settlement terms were incorporated into the Pacesetter agreement, which included two documents: a patent license agreement and a settlement agreement. As part of the Pacesetter agreement, the parties agreed to cross

- license their existing CRDM patent portfolios. The CRDM patent portfolio that Medtronic US
licensed to Pacesetter was closely comparable to the MPROC l icenses
between Medtronic US and MPRO C

. Pacesetter and Medtronic US also settled all other pending litigation between the parties.

As the result of the Pacesetter agreement, Pacesetter was
licensed 342 of Medtronic US’ s patents. MPROC, by comparison, received licenses for upwards of 1,800 of Medtronic US’ s patents. As of May 2004 approximately 9% of the patents licensed by Medtronic US to MPROC were also licensed to Pacesetter in 1992. As of April 2006 approximately 6 .2% of the patents licensed to MPROC were also
licensed to Pacesetter in 1992

.

C. Pacesetter Agreement Terms

The Pacesetter settlement comprised two documents: a patent license and a settlement agreement that resolved patent, antitrust, and unfair competi tion litigation with Pacesetter. The two documents “comprise[d] one agreement and the entire agreement of the parties.” The Pacesetter agreement provided Pacesetter with a nonexclusive
license to certain Medtronic US patents.

As part of the Pacesetter a greement, and to “buy peace,” the parties agreed to cross

- license their pacemaker and patent portfolios. Medtronic US attributed no value to the Pacesetter patents it received as part of the cross

- license. The Pacesetter agreement thus functioned

as a on e

- way license from Medtronic US to Pacesetter

. Upon execution of the Pacesetter agreement

, Pacesetter agreed to pay Medtronic US $50 million up front to compensate Medtronic US for Pacesetter’s past infringement and a $25 million royalty prepayment credit ed against18

[* 18 ] a 1.8% “portfolio access fee” added to the base rates. Both the $50 million and $25 million payments were characterized by Medtronic US as portfolio access royalty payments. Thereafter, Pacesetter agreed to pay Medtronic US a 7% royalty o n CRDM devices and leads sales in the United States and Japan, and a 3.5% royalty on all other international
sales. Medtronic U S did not pay Pacesetter for the license of Pacesetter’s
patents.

As part of the Pacesetter agreement the parties also settled on a maximum rate clause whereby each party could compel a license to any of the other’s CRDM patents developed during the agreement’s term for an aggregate rate of no more than 15%. This meant that Siemens, Pacesetter’s parent company, was entitled to license all of Medtronic
US ’s CRDM patents for an aggregate rate not higher than 15%, which included the 7% royalty that Pacesetter was already paying for current
patents

.

The maximum rate clause was limited by the key patent clause,

a narrow exception under which each party could designate up to three patents per year as “key.” The designation as a key patent provided a roughly three

- year period during which the other party could not compel a license for the patent. During the terms of the P acesetter agreement
Medtronic US did not designate any of its patents as key patents

.

Pursuant to the agreed

- upon 7% royalty rate, Medtronic US received approximately $506 million in royalty payments over the life of the Pacesetter agreement. The amount Medtronic US received exceeded its initial expectations of the total royalty payments it would receive from the Pacesetter agreement. The 7% royalty rate achieved in the Pacesetter agreement was the “most lucrative” deal Medtronic US had
ever achieved and remains one of the highest royalty rates in the pacemaker and defibrillator industry to date.

D. St. Jude’s Acquisition of Pacesetter

The initial term of the Pacesetter agreement was ten years, beginning in August 1992. The parties agreed that if Pacese tter were sold the term would reset, extending the term to 10 years post sale (but not more than 15 years total). The Pacesetter agreement thus contemplated the possibility of an extension through 2007. In September 1994 St. Jude acquired Pacesetter from Siemens. Upon acquisition of Pacesetter, St. Jude assumed all of Siemens’ s rights and obligations under the Pacesetter agreement

. St. Jude did not modify the19

[* 19 ] terms of the Pacesetter agreement and accepted it in whole, including the royalty rate. P er the Pacesetter agreement, the original term reset, resulting in a two

- year extension. Accordingly, St. Jude paid royalties to Medtronic US through September 2004 (i.e., into Medtronic
US ’s 2005 tax year, which began in May 2004 ).

The Pacesetter agreem ent was assigned to St. Jude in its entirety, including the m aximum r ate cl ause. Survival of the maximum rate clause is evidenced by several agreements entered into by St. Jude during the term of the Pacesetter agreement; these agreements refer to
the Pacesetter agreement as being “in full force and effect .” In 1996 St. Jude acquired Ventritex, a CRDM competitor, and the agreement stated
that the Medtronic US agreement was “in full force and effect and will not by its terms terminate by reason of the [ m]erger.” Additionally a 2002 amendment to the Pacesetter agreement confirmed the survival of
the maximum rate clause.

Siemens could have elected to buy out its remaining royalty agreements, instead of selling to St

. Jude. The Pacesetter agreement
inclu ded terms

, in the event of a sale by Siemen s, that Siemens may elect to not transfer its rights under the Pacesetter agreement. The Pacesetter agreement include d terms that provided a formula to calculate a payment for buying the remaining royalty obligat ions.

IV

. Product Recalls

Companies in the implantable medical device industry that encounter significant product quality issues face a number of direct and indirect expenses as a result. These costs include the inherent risk to patients; a negative effe ct on the company’s reputation; loss of market share; a decrease in the affected company’s stock price; a shrinkage of the overall size of the market; legal settlement costs; direct product costs, such as writing off the affected inventory; distracted sale s representatives; potential defection of sales representatives to competitors and related costs to keep sales representatives; other remediation costs relating to the product recall; and the distraction of management from long

- term company goals. Reflect ing the risk that product reliability poses, the history of the implantable medical device industry is littered with companies that were adversely affected, acquired by competitors, or driven out of business altogether because of actual or perceived signif icant product quality issues.20

[* 20 ] In 2005 Medtronic issued a recall of certain of its Marquis family of ICD and CRT devices because of a problem that sometimes led to the battery ’s draining too quickly. This caused a concern that the Marquis
ICD or CRT might fail to deliver appropriate therapy when the patient needed it, which could be fatal. The Marquis recall forced Medtronic US to divert significant research and development (R&D) and other resources to address the underlying issue. Physicians paid c areful
attention to Medtronic US ’s response to the Marquis issue to ensure that the problem had been resolved and would not be “carried forward into other products that [they] were implanting.” The Marquis recall was the first significant recall in the im plantable medical device industry in
almost a decade.

The only reason that Medtronic US did not lose market share as a result of the Marquis issue was that its competitor, Guidant, sustained a rash of recalls of its own as a result of product quality issues during the same period. Medtronic US nevertheless faced significant class
action lit igation on account of the Marquis recall and sustained
substantial out

- of

- pocket product liability expenses per year during 2005 and 2006 (in addition to legal costs) related to that litigation.
Medtronic US ultimately settled the Marquis class action lit igation.
MPROC bore these out

- of

- pocket costs for the Marquis devices it made.

V. Swiss Supply Agreement

Medtronic US, MPROC, and Medtronic Europe entered into the Swiss supply agreement, effective May 1, 2002, which was in effect during 2005 and 2006. Under the Swiss supply agreement Medtronic Europe agreed to use its manufacturing operations in Tolochenaz, Switzerland, to assist MPROC by manufacturing and supplying devices when necessary to meet excess demand. The Swiss supply agreement provide d that Medtronic Europe would pay Medtronic US directly an amount equal to the royalty that MPROC would have paid to Medtronic US if MPROC had manufactured the product and had made the sale itself. Medtronic Europe also agreed to pay Medtronic US directly an amount equal to the MPROC trademark royalty that MPROC would have paid to Medtronic US if MPROC had made the sale itself.

VI. Notice of De ficiency

In an audit of petitioner’s 2002 tax return, respondent analyzed the devices and leads intercompany tran sactions and the transfer prices among MPROC, Medtronic US, and Med USA, as well as the 200221

[* 21 ] restructuring of Medtronic US ’s operations in Puerto Rico. At the conclusion of the examination, respondent accepted the CUT method identified by petitioner and its adviser, Ernst & Young, LLP, but adjusted the transactions to increase their “profit potential

. ” On May 22, 2007, Medtronic US and MPROC entered into amended and restated license agreements effective May 1, 2005. The amendments were made
to refle ct agreements reached in a n MOU between Medtronic US and
the IRS . The amended agreements included a profit split methodology that changed the royalty rates. MPROC would pay a 44% royalty rate to Medtronic US on its net intercompany sales of devices and a 26% royalty to Medtronic US on its net intercompany sales of leads.

Petitioner filed timely its 2005 and 2006 tax returns using the MOU. Respondent’s first examination of petitioner’s 2005 and 2006 tax returns began in approximately May 2007. On December 23, 2010, respondent issued petitioner a notice of deficiency determining deficiencies in tax totaling $198,232,199 and $759,383,578 for 2005 and 2006, respectively. 2 Respondent calculated these deficiencies in reliance on a report prepared by r espondent’s expert A. Michael Heimert, explained in greater detail below, which used the CPM. On July 10, 2014, respondent amended his A nswer to exclude royalty amounts paid by MPROC for non

- U.S. sales, asserting that his adjustments under
section 482 wer e understated by $51,650,809 for 2005 and $59,560,314 for 2006. Thus, the amounts of the proposed deficiencies related to the devices and leads transfer pricing issue are approximately $548,180,115 for 2005 and $810,301,695 for 2006. 3

OPINION

I. Overview of Parties’ Positions

Both parties presented experts to support their respective positions. W e focus on the degree to which expert s’ opinions are

2 These amounts include amounts attributable to issues that the parties have
settled.

3 Since petitioner had increased its income to reflect the royalty rates agreed upon for a prior tax year’s informal resolution, the adjustment does not include the amount by which petitioner had increased its taxable income in reliance on the MOU.
Petition er is now seeking a refund by returning to its book reporting position.22

[* 22 ] supported by the evidence. We do not discuss the opinion of any expert which does not pertain to our factual conclusions

. 4

A. Petitioner’s Position

Petitioner asserts that the Pacesetter agreement can be reliably used to establish the royalty rate for the intangibles licensed to MPROC. It also contends that the Pacesetter agreement is appropriate for u se as a CUT in this case. In its posttrial briefs and at a posttrial hearing petitioner proposed an unspecified method

. See infra Section IV.E. 5

B. Respondent’s Position

Respondent’s position is that the CPM is the best method in this case and that the Pacesetter agreement is not a CUT under the regulatory standards. Respondent rejects petitioner’s proposed unspecified method and argues that it is based upon the same flaw ed methodology used in petitioner’s CUT method. Respondent further argues that petitioner proposes to correct deficiencies in its CUT by making adjustments once again to the Pacesetter agreement which produced “the deficiencies in the first place,” referr ing to respondent’s arguments in Medtronic I that the Pacesetter agreement was not comparable to the MPROC licenses.

II. Applicable Statute and Regulations

Section 482 was enacted to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between
controlled entities. Veritas Software Corp. & Subs. v. Commissioner

, 133 T.C. 297, 316 (2009) . This section gives the Commissioner broad authority to allocate gross income, deductions, credits, or allowances
between two r elated corporations if the allocations are necessary either to prevent evasion of tax or to reflect clearly the income of the corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner

, 102 T.C. 149, 163 (1994)

. The Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless it lacks
economic substance. Treas. Reg. § 1.482

- 1 (f)(2)(ii)(A) . The Commissioner, however, may consider the alternatives available to the taxpayer in determining whether the term s of the controlled transaction

4 See Appendix for experts who testified during the further trial.

5 A remote hearing was held on December 2, 2021, to address issues raised in the parties’ opening posttrial briefs.23

[* 23 ] would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under similar circumstances

. Id. In this type of situation

, the Commissioner may adjust the consideration charged in the controlled transaction according to the cost or profit of an alternative, but the Commissioner will not restructure the transaction as if the taxpayer had used the alternative. See id

.

To determine true taxable income, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Id

. para. (b)(1)

. As in effect during 2005 through 2006, t he regulations provide four methods to deter mine the arm’s

length amount to be charged in a controlled transfer of intangible
property : the CUT method , the CPM, the profit split method, and unspecified methods as described in Treasury Regulation § 1.482

- 4(d)

. See id. § 1.482

- 4(a)

. 6 The best metho d rule provides that the arm’s

length result of a controlled transaction must be determined u sing the method that, under the facts and circumstances, provide s the most
reliable measure of an arm’s

- length result. Id . § 1.482

- 1(c)(1) . There is no strict priority of methods, and no method will invariably be
considered more reliable than another

. Id

. In determining which of two or more available methods provides the most reliable measure of an
arm’s

- length result, the two primary fac tors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of data and assumptions used in the analysis. Id. subpara. (2)

.

A. CPM

The CPM evaluates whether the amount charged in a controlled
transaction is arm’s length according to objective measures of profitability (profit level indicators) derived from transactions of uncontrolled taxpayers that engage in similar business activities under
similar circumsta nces. Id

. § 1.482

- 5(a) . Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. Id. para. (b)(4) . The appropriate profit level indicator depends upon a number of factors, including the nat ure of the activities of the tested party, the reliability of available data with respect to uncontrolled comparables, and the extent to which the profit level indicator is likely to produce a reliable measurement of the income

6 The regulations provide an additional method, the cost plus method, for cases involving the manufacture, assembly

, or other production of goods sold solely to related parties. See Treas. Reg. § 1.482

- 3(d) (1)

.24

[* 24 ] that the tested party w ould have earned had it dealt with controlled taxpayers at arm’s length

, taking into account all facts and
circumstances. Id. See generally Coca

- Cola Co. & Subs. v

. Commissioner

, 155 T.C. 145, 210

– 13, 221

– 37 (2020).

B. CUT Method

The CUT method evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction. Treas. Reg

. § 1.482

- 4(c) (1) . If an uncontrolled transaction involves the transfer of the same intangible under the same or substantially the same circumstances as the controlled transaction, the results derived generally will be the most direct and reliable measure of the arm’s

length result for the controlled tra nsfer of an intangible. Id. subpara

. (2)(ii)

.

The application of the CUT method requires that the controlled and uncontrolled transactions involve the same intangible property or comparable intangible property as defined in the regulations

. Id.
subdiv. (iii)(A) . In order for intangibles to be considered comparable, both intangibles must (i) be used in connection with similar products or processes within the same general industry or market and (ii) have similar profit potential. Id. subdiv. (iii)(B) ( 1 )

.

The profit potential of an intangible is most reliably measured by directly calculating the net present value of the benefits to be realized (on the basis of prospective profits to be realized or costs to be saved) through the use o r subsequent transfer of the intangible, considering the capital investment and startup expenses required, the risks to be assumed, and other relevant considerations. Id . subdiv. (iii)(B) ( 1 ) ( ii )

.

C. Profit Split Method

The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that comb ined operating profit or
loss. Id. § 1.482

- 6(a)

. Allocation under the profit split method must be made in accordance with either the comparable profit split method or the residual profit split method. Id. para. (c)(1)

. The comparable profit split metho d is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to25

[* 25 ] those of the controlled taxpayers in the relevant business. Id.
sub para. (2).

D

. Unspecified Method

Methods not specified in p aragraphs (a)(1), (2), and (3) of Treasury Regulation § 1.482

- 4 may be used to evaluate whether the amount charged in a controlled transaction is arm ’ s length. Any method used must be applied in accordance with the provisions of Treasury Regulation § 1.482

- 1

. Treas. Reg. § 1.482

- 4(d)(1) . Consistent with the specified methods, an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic al ternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it

. Id

. An unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized
b y choosing a realistic alternative to the controlled transaction

. Id

. As with any method, 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

. Id

.

E

. Commensurate w ith Income

In 1986 Congress amended section 482 by adding: “In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license
shall be commens urate with the income attributable to the intangible.”
Tax Refor m Act of 1986, Pub. L. No. 99

- 514, § 1231(e)(1), 100 Stat. 2085,

2562

– 63

.

The House report that accompanied the House version of the 1986 amendment to section 482 explains the reason for cha nge, in relevant part, as follows:

There is a strong incentive for taxpayers to transfer intangibles to related foreign corporations or possessions corporations in a low tax jurisdiction, particularly when the intangible has a high value relative to manuf acturing or assembly costs.

. . .

. . . .

Many observers have questioned the effectiveness of
the “arm ’ s length” approach of the regulations under26

section 482. A recurrent problem is the absence of comparable arm’s length transactions between unrelated parties, and the inconsistent results of attempting to impose an arm’s length concept in the absence of comparables.

. . . .

The problems are particularly acute in the case of transfers of high

- profit potential intangibles . Taxpayers may transfer such intangibles to foreign related corporations or to possession corporations at an early stage, for a relatively low royalty, and take the position that it was not possible at the time of the transfers to predict the subsequent success of the product. Even in the case of a proven high

- profit intangible, taxpayers frequently take the position that intercompany royalty rates may appropriately be set on the basis of industry norms for transfers of much less profitable items.

. . . .

Transfers between related parties do not involve the same risks as transfers to unrelated parties

. There is thus a powerful incentive to establish a relatively low royalty without adequate provisions for adjustment as the revenues of the intangible v ary. There are extreme difficulties in determining whether the arm’s length transfers between unrelated parties are comparable. The committee thus concludes that it is appropriate to require that the payment made on a transfer of intangibles to a
related foreign corporation or possessions corporation be
commensurate with the income attributable to the intangible.

. . .

. . . .

. . . Where taxpayers transfer intangibles with a high profit potential, the compensation for the intangibles should be greate r than industry averages or norms.

. . .

. . . . [* 26 ]27

In requiring that payments be commensurate with the income stream, the bill does not intend to mandate the
use of the “contract manufacturer” or “cost

- plus” methods of allocating income or any oth er particular method. As under present law, all the facts and circumstances are to be considered in determining what pricing methods are appropriate in cases involving intangible property, including the extent to which the transferee bears real
risks with respect to its ability to make a profit from the intangible or, instead, sells products produced with the intangible largely to related parties (which may involve little sales risk or activity) and has a market essentially dependent on, or assured by, suc h related parties’ marketing efforts. However, the profit or income stream generated by or associated with intangible property is to be given primary weight.

H.R. Rep

. No . 99

- 426, at 423

– 26 (1985), reprinted in 1986

- 3 C.B. (Vol. 2) 1, 423

– 26 (footnote omitted)

.

The conference report that accompanied the 1986 amendment to section 482 states, in relevant part, as follows:

The conferees are also aware that many important
and difficult issues under section 482 are left unresolved by this legislation. The conferees believe that a comprehensive study of intercompany pricing rules by the
Internal Revenue Service should be conducted and that careful consideration should be given to whether the existing regulations could be modified in any res pect.

H.R. Rep

. No . 99

- 841 (Vol. II), at II

- 638 (1986) (Conf. Rep.)

, reprinted in

1986

- 3 C.B. (Vol. 4) 1, 638

.

The Treasury Department and the Internal Revenue Service
conduct ed a comprehensive study that was published in 1988. See I.R.S.
Notice 88

- 123, 1988

- 2 C.B. 458 (1988 White Paper) . The 1988 White Paper concluded that the arm’s

- length standard is the norm for making transfer pricing adjustments. Id. at 475 . The 1988 White Paper concluded that Congress intended no departure from the arm’s

- length

s tandard

. Id. The 1988 White Paper explained:

Looking at the income related to the intangible and splitting it according to relative economic contributions is [* 27 ]28

consistent with what unrelated parties do. The general goal of the commensurate with income standard is, therefore, to ensure that each party earns the income or return from the intangible that an unrelated party would earn in an arm’s length transfer of the intangi ble.

Id. at 472

.

The Treasury Department has repeatedly confirmed that Congress intended for the commensurate with income standard to work consistently with the arm’s

- length standard

. See, e.g. , Treasury Department Technical Explanation of the 2001 U.K.

- U.S. Income Tax Convention, art. 9, Tax Treaties (CCH) pa ra. 10,911 at 201,307 (“It is
understood that the ‘ commensurate with income’ standard for determining appropriate transfer prices for intangibles, added to Code section 482 by the Tax Reform Act of 1986, was designed to operate consistently with the arm’s

- length standard.”); Treasury Department Technical Explanation of the 2006 Model Income Tax Convention, art. 9, Tax Treaties (CCH) para. 215 at 10,640

– 41 (same)

.

III. Issues Remaining for Consideration

On the basis of the Eighth Circuit ’ s mandate, the Cour t must make additional factual findings in order to determine the arm’s

- length
allocation of income between Medtronic US and MPROC. In agreeing to reopen the record in its May 3, 2019

, Order , this Court expressly
identified the issues to be considered pur suant to the Eighth Circuit’s
mandate:

(1) w hether the Pacesetter agreement is a CUT ;

(2) w hether this Court made appropriate adjustments to
the Pacesetter a greement as a CUT ;

(3) w hether the circumstances between Pacesetter and Medtronic US were comparable to the licensing agreement
between Medtronic and [ MPROC ] and whether the Pacesetter agreement was an agreement created in the ordinary course of business ;

(4) a n analysis of the degree of comparability of the
Pacesetter a greement’s contractual terms and those of the [ MPROC ] licensing agreement ; [* 28 ]29

(5) a n evaluation of how the different intangibles affected
the comparability of the Pacesetter a greement and the [ M PROC ] lice nsing agreement ;

( 6) a n analysis that contrasts and compares the CUT method using the P a cesetter a greement with or without adjustments and the CPM, including which method is the
best method

.

Th is Court is to decide the amount of risk and product liability expense that should be allocated between Medtronic US and MPROC.

A. Whether the Pacesetter Agreement I s a CUT

In Medtronic I the Court made adjustments to the Pacesetter
agreement in an effort to reach a result that would provide an arm’s

length standard. The result in Medtronic I was not the first time this Court approved the CUT method to measure arm’s

- length prices for intercompany transfers of intangibles. See Veritas Software

, 133
T.C. 297

. A comparable with different royalty rate may serve “as a base
from which to determine the arm’s

- length consideration for the intangible property involved in this case

. ” Sundstrand Corp. & Subs. v.
Commissioner , 96 T.C. 226 , 393 (1991)

.

The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of Treasury Regulation § 1 .482

- 1(d) ; however, specified factors are particular ly relevant to the CUT method. Treas. Reg. § 1.482

- 4(c) (2) (iii ).
Pursuant to Treasury Regulation § 1.482

- 1(d)( 1 )

, the five general comparability factors are (1) functions, (2) contractual terms, (3) risks, (4) economic conditions, and (5) property or services. The application of
the CUT method specifies that th e controlled and uncontrolled
transactions need not be identical but must be sufficiently similar that they provide an arm’s

- length result. Id. subpara. (2)

. If there are
material differences between the controlled and uncontrolled transactions, adjustments must be made if they can be made with sufficient accuracy to improve the reliability of the results. Id. If adjustments for material differences cannot be made, the reliability of the analysis will be reduced. Id.

For intangible property to be considered comparable, the intangibles must be used in connection with similar products or processes within the same general industry or market and have similar

pro fit potential

. Id. § 1.482

- 4(c) (2)(iii) (B)( 1 ) . In evaluating the [* 29 ]30

[* 30 ] comparability of the circumstances of the controlled and uncontrolled transactions the following factors “may be particularly relevant”: (1) the terms of the transfer; (2) the stage of development of the intangible; (3) rights to receive updates, revisions, or modification s of the intangible; (4) the uniquenes s of the property; (5) the duration of
the license; (6) any economic and product liability risks; (7) the existence
and exten t of any collateral transactions or ongoing business relationships; (8) the functions to be performed by the transferor and transferee; and (9) the accuracy of the data and the reliabilit y of assumptions use d

. Id. subdiv s

. (iii) (B)( 2 ) , (iv)

. These factors are often referred to as the circumstantial comparability factors.

The Pacesetter agreement is not identical to the MPROC licenses. In the light of the Eighth Circuit’s remand, we mus t analyze the general comparability factors to determine whether the Pacesetter agreement and the MPROC licenses are similar enough to meet the comparability requirements of the regulations.

Of the five general comparability factors, we conclude that the functions, economic conditions, and property or services are not comparable. Therefore, the Pacesetter agreement is not a CUT.

1. Functions

Determining the degree of comparability requires a n analysis
that looks at the functions of the two transactions s uch as R&D ; product design and engineering ; manufacturing ; product fabrication ; purchasing
and material s management; marketing and distribution functions; transportation and warehousing; and managerial

, legal

, accounting

, and other personnel management services. Id. § 1.482

- 1 (d)(3)(i). A functional analysis is not a pricing method and by itself does not
de termine an arm’s

- length result. Id.

Respondent argues that the transactions are not comparable because different functions were performed. As a licensor under the MPROC agreement, Medtronic US performed R&D with respect to MPROC products that was 8.2% an d 9% of revenues respectively for 2005 and 2006. Additionally, Medtronic US spent 4.3% of revenues and 5% of revenues respectively for 2005 and 2006 on business management
activities for CR D M and Neuro. However, in the Pacesetter agreement,
Medtronic US as licensor did not perform R&D to develop Pacesetter products

, nor did it perform any other activities to help Pacesetter market its products. Pacesetter performed these services as a licensee

.31

[* 31 ] MPROC’s function was that of a finished manufacturing of
class III medical devices, and this differs from Pacesetter because Pacesetter also performed R&D, component manufacturing, and distribution. Therefore, we conclude MPROC and Pacesetter did not perform the same functions.

2. Economic Conditions

The Pacesetter agreement has a “horizontal” relationship because the agreement is between competitors. The MPROC license has a “vertical” relationship because the agreement is between a corporation and a controlled subsidiary. Respondent contends that the ag reements cannot be comparable because of the different type s of relationships.

The section 482 arm’s

- length standard is premised on the princip le that a controlled transaction is compared to an uncontrolled
transaction. See Treas

. Reg. § 1

. 482

- 1(b) . The regulations do not require
that both transactions compared have vertical or horizontal relationships. The regulations provide examples in which a controlled transaction is compared with transactions between a third party and a competitor. See id. § 1.48 2

- 4(c)(4) (e xamples 1 and 3 ) . We disagree with respondent’s position that the Pacesetter agreement and the MPROC
licenses can not be comparable because a transaction with a vertical relationship and one with a horizontal relationship are being compared.

E ven though we dis agree with respondent’s position regarding the relationships between transactions being compared, we still have

concerns. In this case we can find only one transaction

— the Pacesetter
agreement

— that comes close to being a CUT ; however, we have concerns about the profit potential. The CUT method does not address adequately our concerns about the profit potential. Furthermore, we are concerned that there is only one comparable transaction with which to compare the MPROC licenses

.

Responden t contends that the profit potential of the Pacesetter agreement and that of the MPROC licenses are not similar. We
concluded in Medtronic I that petitioner’s expert Louis Berneman’s analysis did not include a comparison of profit potential consistent with the regulations ’ requirement that the profit potential be similar. See
Medtronic I

, at *129

. Respondent’s expert Heimert’s analysis shows
there was a diffe rence between MPROC’s product profit margin of 54%
and Pacesetter ’s product profit margin of 29%. His analysis also shows that revenues for Pacesetter products were $233 and $361 million32

[* 32 ] versus $2.68 and $3.54 billion for Medtronic products for 2005 and 2006, respectively. Because of the difference in profit potential, we conclude that the economic conditions are not comparable.

3. Property or Services

The Pacesetter and the MPROC licenses include comparable products; however, the Pacesetter agreeme nt does not include N euro products

. T his is not enough to make the products not comparable. To
determine whether the products are comparable, we need to look at the property and the services provided. The intangible property licenses under the MPROC agr eement include secret processes, technical information, technical expertise relating to the design of devices and leads, and all legal rights including know

- how. The total number of patents available to MPROC under the licenses reached 1,800 in 2006

,

w hereas the Pacesetter agreement licensed 342 patents. Accordingly, we conclude that the product s licensed are not similar.

Furthermore, the determination of whether the products and services are considered comparable is similar to the determination of
wh ether the functions are comparable. For the same reasons that we conclude the functions are not comparable, we conclude the products and services are not comparable.

Three of the five general comparability factors are not met, and
this raises concerns ab out the CUT as proposed by petitioner. Taking into consideration economic conditions, property or services , and functions, we conclude that the Pacesetter agreement and the MPROC licenses do not meet the general comparability factor requirements.
Since w e conclude that the general comparability factors are not met, we do not need to analyze the circumstantial comparability factors to determine whether the Pacesetter agreement is a CUT.

B. Whether the Tax Court Made Appropriate Adjustments to
the Pacesette r Agreement as a CUT

Petitioner contends that appropriate adjustments may be made to the Pacesetter agreement and that the P acesetter agreement with appropriate adjustments remains a CUT . Petitioner’s expert Jonathan
Putnam made adjustments to the CUT an d proposed two approaches. One approach started with a 7% royalty rate, and the other approach started with a 15% royalty rate. For both approaches Putnam calculated a low and high wholesale royalty rate. These adjustments differ from
the Court’s adjust ments in Medtronic I . The major difference is the33

[* 33 ] Court made an adjustment for leads by decreasing the rate for devices by 50 % , instead of having the same royalty rate for both devices
and leads. See Medtronic I

, at *1 38

.

Respondent’s position is t hat there are no appropriate adjustments that can be made to the CUT. Respondent further contends that the Court’s adjustments were not in compliance with the regulations and that making adjustments compound s the chances of

error.

In the light of the Eig hth Circuit’s mandate we have reviewed our adjustments in Medtronic I and conclude that adjustments can be made

to the Pacesetter agreement ; however, too many adjustments result in the Pacesetter agreement as a CUT not being the best method pursuant to the section 482 regulations. During the further trial we heard from

ten experts and have reached the conclusion that the outcome in
Medtronic I should be changed

. See infra Section IV.D

.

C. Whether the Circumstances B etween Pacesetter and Medtronic US Were Comparable to the Licensing Agreement B etween Medtronic US and MPROC and Whether the Pacesetter Agreement Was an Agreement
Created in the O rdinary Course of Business

Treas ury Reg ulation § 1.482

- 1(d)(4)(iii)(A)( 1 ) provides that transactions “ordinarily will not constitute reliable measures of an arm’s length result” if they are “not made in the ordinary course of business.”

Treas ury Re g ulati on § 1.482

- 1(d)(4) (iii)(B) ( e xample 1 ) provide s an example of a transaction not in the ordinary course of business. In t his example a U.S. manufacturer sells its products to an unrelated
distributor. This manufacturer is forced into bankruptcy and sells all
its inventory at a liquidation price. Since this sale was due to bankruptcy

, it is not treated as a sale in the ordinary course of bus iness.

The Pacesetter agreement occurred in the context of resolving litigation. The Pacesetter litigation clarified Pacesetter ’s and Medtronic
US’ s rights and obligations over Medtronic US patents

.

Petitioner’s experts Richard Cohen, Fred McCoy , and C hristopher Spadea testified that patent litigation and settlement licenses were and are common in the CRDM industry. Litigation can help the parties become informed as to their respective legal rights and obligations. It can resolve, rather than cast dou bt on, a patent’s value. Putnam testified that “litigation actually helps us draw better inference s about34

[* 34 ] the value of the IP.” He explained that if there is concern about the role of litigation, the 15% provision in the Pacesetter agreement
should be looked to because it is unrelated to the patents that were being litigated in 1992. The 15% provision in the Pacesetter agreement is the maximum royalty rate and is for patents identified as key patents.

Often

, in the absence of a lawsuit, royalty neg otiations are based upon the outcome that the parties would expect in litigation. A patent license provides an arm’s

- length transaction between two private parties that places a monetary value on the patent. Jonathan S. Masur, The Use and Misuse of Patent Licenses , 110 Nw. U. L. Rev

. 115, 120 (2015).

The Pacesetter agreement included a broad cross

- license that included patents in addition to those subject to the dispute between
Medtronic US and Pacesetter. St. Jude’s a cquisition of Pacesetter reinforces that the Pacesetter agreement was created in the ordinary
course of business. When St. Jude acquired Pacesetter in 1994, it had
to determine whether to accept and to continue the terms of the Pacesetter agreement. The decision to continue the agreement was
made in a commercial setting.

The value of discontinuing the case for Medtronic US was small compared to the income from a royalty rate. Petitioner expected that continuing litigation with Pacesetter would c ost an additional $17
million

. The expected cashflow of the license to Pacese tter was over $205 million. Putnam contends that if the cost of litigation is small in relation to the total payment, then avoided litigation costs would
constitute only a small fraction of the payment made to the licensor.

Put nam further testified that parties resolving a patent infringement lawsuit, and parties who are deciding whether to enter into a commercial license over patent rights

, share several key considerations. He explained that there is not an established bright

- line
rule as to when the pa rties begin considering litigation in the context of their negotiations. He stated : “[A]ll licenses are negotiated ‘in the shadow’ of litigation, because all licenses only pay royalties when circumstances ‘compel’ them to do so.” His view is that the lic ensee’s profit

- motivated evaluation of that compulsion exists whether actual litigation exists or not and that these evaluation s are therefore ordinary. He explained that litigation costs are not distortionary because both parties avoid litigation costs.35

[* 35 ] Petitioner’s expert Cohen testified about the evolution of cross

licenses in the cardio device industry. He explained that the experience in the industry was that patents were potent weapons that could enable the patent holder to delay a company from introducing an important feature or product critical to commercial su ccess of that company. He compared the patent process in the cardio device industry to navigating a minefield. According to his testimony, the process became a minefield because the devices were complex with many features. He explained
that each of the major competitors was at risk that there would be a major innovation and that any one of them might be blocked from introducing products incorporating this innovation.

His assessment is that the major competitors realized eventually that they would be bet ter off cross

- licensing their patent portfolios and focusing on developing the markets. He contends that by cross

- licensing broad patent portfolios, the major competitors could eliminate the costs of attempting to engineer around each other’s patents and the costs of litigation. Cohen explained that companies in the cardio device industry developed patents to protect their individual innovations, and these patent portfolios interfered with the ability of each of the companies in the space to introduce pro ducts that incorporated all the medically important and attractive features without the risk of being sued. He
reached the conclusion that cross

- license agreements following litigation or threatened litigation became part of the ordinary course of busines s in the cardio device industry.

We conclude that the Pacesetter agreement was reached in the ordinary course of business; however, this conclusion is not enough to conclude that the Pacesetter agreement was a CUT for the purpose
section 482.

D

. An Analys is of the Degree of Comparability of the Pacesetter Agreement’s Contractual Terms and Those of the MPROC Licensing Agreement

There are enough differences between the Pacesetter agreement and MPROC licenses to conclude that the Pacesetter agreement was not a CUT; however, there are enough similarities that the Pacesetter agreement can be used as a starting point for determining a proper royalty rate. The terms of the payment s are comparable. See Treas. Reg. § 1.482

- 4(c)(2)(iii). Both agreements had runnin g royalty rates base d on sales of devices and leads. See id. § 1.482

- 1(d)(3)(ii)(A)( 1 ).36

[* 36 ] Petitioner’s expert Putnam testified that the base royalty rate paid by Pacesetter may be viewed as the net of two claims: Medtronic
US ’s claim on Pacesetter’s sales, less Pacesetter’s claims on Medtronic
US ’s sales. Pacesetter’s claim s on Medtronic US were minimal. According to the Pacesetter agreement, the parties agreed that Pacesetter’s grant of patent rights was royalty free and fully paid up.
He estimated that the value of Pacesetter’s claim s against Medtronic US
at the time of the Pacesetter agreement was to be 0.5% to 1% of
Pacesetter’s sales. Medtronic US did not benefit substantially from the

cross

- licensing provisions.

The lump

- sum pay ment of $50 million for past infringement does not undermine comparability. Putnam testified that the $50 million payment does not contaminate the inferences to be drawn from the Pacesetter agreement based on his analysis, which shows that past sales
had about the same royalty rate of the going forward rate of 7%. The $25 million prepaid credit against a portion of the future running royalty
rate can be accounted for by a 1.8% upward adjustment as suggested by
Putnam.

In 1994 St

. Jude bought Pacesetter

, and this resulted in an extension of the Pacesetter agreement. When St. Jude acquired Pacesetter, it evaluated the Pacesetter agreement and came to the same conclusion that the royalty rate was appropriate. St. Jude did not seek to modify the Pacesetter agreement. There is no evidence that St. Jude tried to change the Pacesetter agreement post acquisition.

Petitioner contends that there was no paradigm shift in the time between the Pacesetter agreement and the MPROC licenses. The 7% royalty rate was am ong the highest rates in the industry. McCoy testified that the rate of 7% and the initial rate of 8.8% were high for the industry. He is not aware of any royalty rate in the CRDM industry which is higher.

Petitioner’s expert Cohen concluded that betwee n 1992 and 2004,
there was no “ technological paradigm shift” in the CRDM industry. He explained in his report that the Mirowski patent was issued in 1990 and was the foundation patent for CRT devices. He concluded that
advancements were made in 2002 and these advances simply involved additional pacing functionality. His analysis supports that there was no paradigm shift because there was no sustained increase in market growth.37

[* 37 ] Petitioner’s expert Glenn Hubbard testified that the gross margins of Me dtronic US , Boston Scientific, Guidant, and St. Jude did not show any dramatic change from 1992 to 2006. He referenced a 2005 Morgan Stanley report which estimated that Medtronic US ’s 2004 gross profit margin of 75.2% would increase to 76.8% by 2010. Hub bard concluded no adjustments to royalty rates specified in the Pacesetter agreement are needed to account for broad changes in the medical device industry during 2005 and 2006.

The Pacesetter agreement I ncluded a maximum rate of 15%

, which was for key patents

. This shows that Medtronic US was offering its CRDM portfolio to St. Jude for no more than 15% through 2004, and
this was about the same time the MPROC licenses w e re negotiated.
Medtronic US never designated any patents as key patents. This
in ac tion supports that there was not a paradigm shift.

Even though there is a level of comparability between the Pacesetter agreement and the MPROC licenses, it is not enough to conclude that the CUT is the best method for the reasons previously
discussed. T he comparability of contractual terms is just one of many
factors that needs to be considered.

E. An Evaluation of How the Different Intangibles Affected the Comparability of the Pacesetter Agreement and the MPROC Licensing Agreement

Generally, intangible property is considered comparable if it is used in connection with similar products . Treas. Reg. § 1.482

- 4(c)(2)(iii)(B)( 1 )( i ). We have concluded previously that the intangibles are not comparable enough to meet the general comparability factors.
See su pra Section III.A.

F. An Analysis T hat Contrasts and Compares the CUT Method Using the Pacesetter Agreement w ith or W ithout Adjustments and the CPM, Including Which Method I s the
Best

Under the CUT method, controlled and uncontrolled transactions

must inv olve the same or comparable in tangible property

, and
differences in contractual terms and economic conditions should be
considered. See Treas. Reg. § 1.482

- 4(c)(2)(iii)

. The regulations provide
contractual and economic factors to assess the comparab ility of
circumstances between a controlled and an uncontrolled transaction for
the CUT method. See i d. subdiv. (iii)(B)( 2 )

. These factors were38

[* 38 ] discussed supra Section III.A.

, and we concluded that the general comparability fact or s were not met and the circumstantial comparability factors need not be considered.

In the Court’s previous O pinion we found that the royalty rates petitioner proposed are not arm’s length because appropriate adjust ments were not made to the CUT method to account for variations in profit potential. See Medtronic I

, at *129 . We concluded that “Berneman’s analysis unacceptably lacks an examination of the profit potential of his comparable transactions, including the Paces etter agreement as defined by regulations.” Id. We have not changed our view regarding the Berneman analysis and still find that it is necessary to make adjustments to the Pacesetter agreement.

Respondent contends that the Pacesetter agreement was not a CUT because the patent licenses were not comparable and the
Pacesetter agreement was not entered into in the ordinary course of business. Respondent further contends th at using the Pacesetter agreement as a CUT result s in MPROC ’s receiving the “lion ’s share” of profits earned from the sales of CR D M and N euro products. This line of argument raises the question of w hy MPROC’s profitab i l it y dwarfs th at of Medtronic US, the owner of the “crown

- jewel” intangibles

.

Respondent compares the MPROC licenses to the arrangement
Coca

- Cola had with its affiliates. A CPM analysis was appropriate for the nature of the assets and the activities performed by the controlled taxpayers in Coca

- Cola Co. , 155 T.C. at 21 7

– 18

. The nature of the assets

own ed and the activi ties performed by MPROC are not comparable. In
Coca

- Cola Co. the manufacturing process entailed forms of extraction, filtration, mixing, blending, aging, and precision filing. The affiliates performed routine quality control pursuant to detailed specifica tions from the U.S. parent. Id . at 159

– 60. With one exception, the affiliates had no employees of their own specifically dedicated to quality

assurance. Id . at 160. The taxpayer’s experts agreed that the affiliates’ manufacturing activity was a routine activity that could be benchmarked to the activities of contract manufacturers, meriting compensation no greater than cost plus 8.5%. Id

. The manufacturing
of sweete ned beverage s under these circumstances does not compare to the manufacturing of life

- saving devices for which quality is of the utmost importance. We previously concluded that the role of MPROC was more than that of a routine manufacturer of finished pro ducts.
Medtronic I

, at *1 06

– 08.39

[* 39 ] Respondent maintains the same position from Medtronic I that the CPM is the best method to price the MPROC licenses. In Medtronic I
we concluded that an allocation of 6 %

– 8% was not reasonable. Id.

at *117 . Responde nt is asking the Court to reconsider its position and
conclude that Heimert’s original CPM is the best method . The Court is not going to reverse its o pinion that petitioner met its burden of showing that respondent’s allocations were arbitrary and caprici ous. See id.

at *118

.

Petitioner’s expert Hubbard testified about the challenges of conducting a CPM with regard to the MPROC licenses and the importance of the tested party. Heimert used MPROC as the tested party. Hubbard explained that the tested par ty is critical because residual profits are attributed to the nontested party. He explained further that choosing one tested party or the other can yield substantially different results, and thus substantially different estimates of royalty rates. He con cludes that when the tested party predominantly performs one business function, as did MPROC, it is important to select comparables that predominantly perform the same business function. According to Hubbard, it is preferable to choose as the tested party the entity whose functions, activities, and risks can be benchmarked most reliably to comparable companies.

Hubbard testified that neither Medtronic US nor MPROC is an obvious candidate to serve as the tested party because neither Medtronic
US nor MPROC has functional roles and risks that can be easily benchmarked. Additionally, he was critical of Heimert’s selection of MPROC as the tested party. Hubbard concluded that the Heimert CPM is incomplete because it fails to give proper consideration to the fact that MPROC performed nonroutine functions such as ensuring product quality and assuming the risk for product liability.

The CPM benchmarks the arm’s

- length level of operating profits earned by the tested party with reference to the level of operating prof its earned by comparable companies. See Treas. Reg. § 1.482

- 5 (b)(1). According to Hubbard

, from an economic perspective certain product characteristics should be considered in assessing the comparability of companies. His report indicated that the FDA e stimates that about 10% of medical devices receive the class III designation. He concludes that the risks and returns are much lower for class I devices than they are for class III devices. Class II devices, such as powered wheelchairs, pose a higher ris k to patients but differ from class III devices, which sustain or support life. Hubbard explained that a company that largely40

[* 40 ] produces elastic bandages is unlikely to be comparable to a company that largely produces implantable pacemaker s , even thoug h both companies “produced medical devices.”

Hubbard concludes that a CPM analysis will be unreliable when
there are material differences in factors that affect profitability, such as varying cost structures, differences in business experience, and
differ ences in management efficiency. In his report he conducted a search to find comparables to MPROC but did not find any. He reached this conclusion by searching FDA databases for class III companies. With the exception of Greatbatch Medical (Greatbatch)

, none of Heimert’s comparables produced exclusively class III devices.

Hubbard further testified that there is a distinction between
medical devices that are short lived and those that are long lived. Implantable devices are considered short lived because each is provided only once to a single patient. According to Hubbard

, short lived medical devices tend to have high operating margins, as they significantly improve patient health and are subject to high rates of reimbursement
for healthcare providers. In contrast he explained that long lived products, such as hospital beds or syringes, often have lower profit margins.

Hubbard concluded that there were no appropriate comparables if MPROC were the tested party. We also raised concerns about
Heimert’s com parables in Medtronic I

. See Medtronic I

, at *109

– 12. In the light of the Eighth Circuit’s mandate w e have ree xamined the CPM
metho d and reach the same conclusion that we did in Medtronic I that the use of Heimert’s original CPM was an abuse of discretion. Id

. at * 118. The Court’s CUT in Medtronic I require s to o many adjustments

, and the CPM results in an unrealistic profit split and too high a royalty rate

. Therefore, we conclude neithe r method is the best
method.

G. Allocation of Product Liability Expenses

Pursuant to the MPROC licenses all the product liability risk was allocated to, and borne by, MPROC. Similarly, under the Pacesetter agreement all risk was borne by Pacesetter. Res pondent contends that product liability ri s k did not rest exclusively with MPROC under the intercompany agreements. The MPROC license states that MPROC is “liable for all costs and damages arising from recalls and product
defects. ”41

[* 41 ] Pursuant to the r egulations “the consequent allocation of risks

. . . that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions.” Treas. Reg. § 1.482

- 1(d)(3)(ii)(B ) ( 1 ) . The regulations specify that risks include product liability risks. Id. subdiv. (iii)(A) ( 5 ) . MPROC’s assumption of the product liability risk was consistent with the economic substance
because MPROC had the financial capacity to bea r the burden of the product liability risk. MPROC had managerial and operational control over the manufacturing operations for the finished devices and leads.

Respondent contends that a $25 million adjustment can be made to the CPM to adjust for the assu mption that MPROC bore all product liability costs for CRDM and N euro products. According to respondent’s
expert from the prior trial Paul Braithwaite the ultimate claim ed costs for injuries and related legal expenses were $2 5 .2 million and $26.2
million for 2005 and 2006, respectively

. In contrast petitioner’s expert
from the prior trial Paul Dowden testified that the value of the product liability insurance Medtronic US received from MP R O C during 2005 and 2006 was between $220 million and $235 million f or each year.

MPROC had two responsibilities for managing product liability. First, MPROC needed to minimize the potential for product failures by making every effort to ensure that its finished devices and leads were manufactured to the highest standard s. Second, MPROC was responsible for restoring product quality and bearing all associated product liability costs.

Petitioner’s expert Hubbard testified that, in theory, MPROC had uncapped exposure to product liability risk; however, in practice,
MPROC’s liability would be capped by the aggregate value of all its assets that could be made available to cover the product liability related claims and costs. He discussed the value of prior recalls. MPROC had product liability cost s of $117 million of the $2 05 million total costs from the Marquis device recall and $271 million of the $324 million total costs of the Sprint Fidelis defibrillator lead recall. He explained that certain costs were allocated to other Medtronic entities in compliance with the
MOU e ntered into between petitioner and respondent.

Respondent has proposed a product liability adjustment of $25 million per year as part of the proposed modified CPM. This adjustment
is not in line with the cost s associated with prior recalls. We are not42

[* 42 ] convinced by the evidence that respondent’s adjustment is enough to account for MPROC’s role regarding product liability claims.

I V. Best Method

A. Introduction

In Medtronic I we reviewed respondent’s s ection 482 reallocations for abuse of discretion. On remand the Eighth Circuit did not overrule this holding, nor did the Eighth Circuit hold that this Court’s choice of transfer pricing was incorrect. Rather, the Eighth Circui t found that the analysis in this case required more detailed comparison and explanation as to comparability of circumstances, contractual terms, intangibles, and risk and product liability expense, without mention as to the appropriateness of any particul ar method.

At trial both parties mostly maintained their original positions regarding which transfer pricing method is the best method as it relates to the royalty rates for devices and leads. In the light of the Eighth
Circuit’s mandate we now analyze t he testimony provided by expert witnesses from both parties.

B. Analysis of Respondent’s Position

Respondent maintains the position that the CPM is the best method and continues to rely upon the analysis of Heimert. In his analysis for the further trial Heimert kept MPROC as the tested party and the same 14 companies to benchmark the return to MPROC. His analysis concludes that the technology wholesale royalty rates are 64.3% and 68.4% for 2005 and 2006, respectively

. 7

During trial Heimert testified that the 14 comparables could be reduced to the comparables that made implantables. At the conclusion
of the further trial

, he made alterations to his CPM. Instead of using 14 comparables, calculations were made using 5 of the 6 comparables that
manufactured implantables. Greatbatch was excluded because of its manufacture of components rather than devices. Heimert testified that he was not able to find any companies that performed a role similar to
MPROC which was the manufacturer of devices and leads, class III products.

7 These rates do not account for the 8% trade mark wholesale royalty rate which
was addressed in Medtronic I

.43

[* 43 ] The only other adjustment Heimert made was for product liability. Respondent

, assuming arguendo that MPROC bore all product liability risk , made adjustment s to account for product liability. T hese adjustments are $25.2 million and $26.2 million for 2005 and 2006, respectively

.

Respondent’s calculations reducing the number of comparables and making an adjustment for product liability result in wholesale royalty rates of 59. 6 % for 2005 and 64% f or 2006. We refer to this calculation as respondent’s modified CPM

. The modified CPM would result in total system profits for MPROC of 14% in 2005 and 12% in

2006. Respondent did not suggest an unspecified method and is opposed to using an unspecified method. 8

When the Commissioner has determined deficiencies based on section 482, the taxpayer bears the burden of showing that the allocations are arbitrary, caprici ous, or unreasonable. See Sundstrand Corp. , 96 T.C. at 353 ( first citing G.D. Searle & Co. v. Commissioner , 88 T.C. 252, 35 8 (1987) ; and then citing Eli Lilly & Co. v. Commissioner , 84 T.C. 996, 1131 (1985 )

, aff’d on this issue, rev’d in part and remanded

, 856 F.2d 855 (7th Cir. 1988)). The Commissioner’s section 482 determination must be sustained absent a showing of abuse of
discretion. See Bausch & Lomb, Inc. v. Commissioner , 92 T.C. 525, 582 (1989), aff’d , 933 F.2d 1084 (2d Cir. 1991). “Whether resp ondent has exceeded his discretion is a question of fact.

. . . In reviewing the reasonableness of respondent’s determination, the Court focuses on the
reasonableness of the result, not on the details of the methodology used.” Sundstrand Corp. , 96 T.C. at 353

– 54; see also Am. Terrazzo Strip C o. v. Commissioner , 56 T.C. 961, 971 (1971).

The modified CPM result s in retail royalty rate s of 40.7% and 48.8% for 2005 and 2006, respectively, and wholesale royalty rates of
59.6% and 64% for 2005 and 2006, respectively, whereas the CPM
without modifications resulted in wholesale royalty rates of 64.3% and 68.4% for 2005 and 2006, respectively . T he modified CPM results in
MPROC ’s earning 14% of the profits in 2005 and 12% of the profits in
2006. The CPM without modifications results in MPROC ’s earning 8.1%

8 In respondent’s supplemental brief, respondent included a chart that shows various wholesale royalty rates, including a Pacesetter comparable profit split method resulting in a wholesale ro yalty rate 62.4%. Respondent provided no analysis for this
method

.44

[* 44 ] of the profits in 2005 and 5.6% of the profits in 2006. See
Medtronic I

, at *95.

The problems that Medtronic I addressed regarding Heimert’s CPM remain the same. Even reducing the comparables from 14 to 5, they still have fundamentally different asset bases and involve different
functions and risks from those of a c lass III medical devic e manufacturer. Heimert limits the comparables to Bard

, Inc. (Bard)

, Orthofix International NV (Orthofix) , Stryker, Wright Medical Group

, Inc. (Wright Medical Group) , and Zimmer Holdings

, Inc. (Zimmer)

. Four of these companies manufactured orthopedic dev ices, including reconstructive orthopedic devices. The other company made a broad range of vascular and urology products. None of the five made similar cardio or neuro devices. Additionally, none of the fi v e companies performed only the function of finished device manufacturing. All five performed some combination of the following functions: R&D, component manufacturing, finished medical device manufacturing, and
distribution.

Petitioner’s expert Hubbard expressed concern regarding
Heimert’s subset of five companies because all of the companies also made class I and/or class II devices, not just class III devices as petitioner did. According to Hubbard, limiting the comparables to implantables resulted in blended profitability measures across the

s everal functions of Heimert’s comparables when only one of those functions, the manufacturing of medical devices, is relevant for the CPM in this matter. Even with reducing the number of comparables, the remaining companies are still not good enough compa rables to result in
the CPM ’s being the best method.

Hubbard explained that MPROC focused exclusively on manufacturing finished medical devices, specifically c lass III medical devices. He opined that to be able to use the CPM, comparables should
“conduct similar functions and bear similar risks.” He contends that if Heimert’s comparables focused exclusively on class III finished medical device manufacturing

, then his CPM would appropriately treat MPROC

as the “pure

- play manufacturer of class III medical devices that it was.”

Even if Heimert’s comparable s are reduced to five companies that make implantable devices, there are still flaws with the comparables.

Hubbard explained that a company’s products are among the factors that influence the company’s pr ofitability. He disagreed with Heimert’s position that narrowing the set of comparables to the45

[* 45 ] implantables does not affect the overall range of return on assets (ROAs). Hubbard’s calculations show that the median ROA for the six implantables (inclu ding Greatbatch) is 4 0.4 % from 2003 to 2005 and the median ROA for 14 comparables is 28.1%. From 2004 to 2006 the median ROA for the six implantables is 40.5%; whereas, the median for the 14 comparables is 26%.

The regulations provide that when determini ng which method provides the most reliable measure of an arm’s

- length result, the two primary factors to take into account are (1) the degree of comparability between the controlled transaction (taxpayer) and any uncontrolled comparables and (2) the qualit y of the data and assumptions used in the analysis. Tre a s. Reg. § 1

. 482

- 1(c)(2) . Heimert’s CPM analysis falls short regarding the comparables and assumptions used. See Medtronic I

, at *109

– 14

.

Hubbard explained that even though the five companies making implantables have higher ROAs

, his view has not changed regarding the CPM. He contends that the five comparables that Heimert classifies as
makers of implantables do not represent a profit level indicator of pure

play implantable medical device manufacturers. Two of the five were engaged in R&D, component manufacturing, and distribution, in addition to finished medical device manufacturing. The other three
were involved in R&D and distribution, aside f rom finished medical
device manufact uring. All five companies made class I and/or class II
devices in addition to class III devices. Both Hubbard and Heimert agree that data limitations prevent extracting information pertaining to only class III finished medical devices from the aggregate financial data.

Hubbard contends that the comparability with respect to size of the comparable company does matter. He criticizes Heimert’s analysis for the range in the size of companies and asserts that there is no justification for Heimert to include companies with lower or higher levels of revenue or operating assets than MPROC in his comparables. When analyzing comparable companies, Hubbard looked at the size of the companies and used revenues as a proxy. He was unable to identify companies similar in size to MPROC. Only one of Heimert’s five comparables (Bard) had revenues comparable t o MPROC’s revenues of approximately $2 billion in 2005. 9 Stryker and Zimmer had over double
MPROC’s revenues w hereas Wright Medical Group and Orthofix ha d
less tha n half of MPROC’s 2005 revenue. Additionally, Hubbard’s

9 MPROC’s revenue for 2005 based on Hubbard’s calculations.46

[* 46 ] criticism of the selection of MPROC as the tested party still applies to respondent’s CPM.

Respondent contends that the CPM is the best method and
commensurate with income. The commensurate wi th income standard does not specify a specific method or a certain range of profits. The
modified CPM results in an allocation of 86.9% of the profits to
Medtronic US and Med USA and 13.1% to MPROC. 10 Heimert’s original CPM analysis concludes that 6%

– 8% of the system profits should be
allocated in order for the transactions to be arm’s length. See id. at *119.

MPROC was an FDA

- registered facility responsible for putting together sophisticated medical devices that would remain in the human body for years. See id. at *107 . All the components for the devices and leads could be made perfectly, but there could be p roblems if they are not put together perfectly. Id

.

Hubbard concluded that MPROC played a pivotal role in ensuring the quality of finished CRDM and Neuro devices and leads. He explained that the quality of such class III medical devices was “paramount” because their failure could prove fatal to patients. MPROC employed a highly trained workforce that was ultimately responsible for inspecting finished devices and leads, ensuring that the finished devices functioned property. Hubbard concluded that quali ty is more important for a manufacturer solely of class III devices than for the companies Heimert selected as comparables.

The modified CPM is a minor change to the CPM. The modifications are not enough to overcome the flaws. The adjustment for product liability is inadequate. See supra Section III.G. Therefore, the
modified CPM is not the best method and there is an abuse of discretion by respondent which is due to the use of flawed comparables. Petitioner
has shown that respondent has implemented hi s methodology in an unreasonable manner, e.g.

, by employing erroneous assumptions, incorrect data, or analysis that is internally inconsistent. See Coca

- Cola
Co. , 155 T.C. at 203; see also Veritas Software

, 133 T.C. at 323

– 27 (finding allocations based on a discounted cashflow methodology unreasonable where the Commissioner “employed the wrong useful life, the wrong discount rate, and an unrealistic growth rate”); Altama Delta Corp

. v. Commissioner

, 104 T.C. 424, 466 (1995) (finding all ocations unreasonable where the Commissioner implemented his cost

- plus

10 This calculation is an average for 2005 and 2006.47

[* 47 ] method by marking up operating profit margins instead of gross profit margins); Seagate Tech., Inc

., 102 T.C. at 192 (rejecting expert ’ s pricing of component parts upon finding that his methodology “d[id] not meet the description of the cost

- plus method” in the regulations); Achiro

v. Commissioner

, 77 T.C. 881, 900 (1981) (rejecting the Commissioner ’ s allocation where he made no “reasonable attempt[] to reflect arm ’sleng th transactions among the related entities”). In this case the use of comparables that did not make solely class III medical devices, as were the devices finished manufactured by MPROC, resulted in an abuse of discretion by respondent.

C. Analysis of Petitioner’s Position

Petitioner relies on the testimony of its expert Putnam to determine royalty rates . Petitioner maintains it s position that the CUT
is the best method and that the Pacesetter agreement is a valid CUT.

Putnam offered two approaches a djusting the royalty rate

, and for both approaches he estimated low and high rate s . The first approach using retail royalty rates starts with a 7% rate , the rate of the Pacesetter
agreement . The resulting wholesale royalty rates under this approach

are 2 2.3% and 33.4% for cardio and 17. 9 % and 27.5% for N euro. The second approach starts with 15% retail royalty rate which is equivalent to the maximum rate in the Pacesetter agreement

. The wholesale royalty rates under this approach are 29.4% and 33.8% for cardio and
25% and 27. 9 % for N euro

.

Putnam made an adjustment to the Pacesetter agreement to account for profit potential. This adjustment is to account for the
differences between Pacesetter in the 1992 to 1994 timeframe and petitioner’s CRDM business in the 2003 to 2005 timeframe. His conclusion is that a retail rate adjustment of 0.9%

– 4.9% is needed. His
report states : “That adjustment is not linked to any particular source; any such linkage would be inherently imprecise, because the two companies’ fi nancial statements do not reliably reveal the cause of these
differences.”

Putnam’s suggested adjusted retail royalty rate increase of 0.9%

– 4.9% is a broad range. In Medtronic I we concluded that a retail royalty adjustment of 3.5% is necessary to accoun t for the difference in profit potential. Evidence presented during the further trial did not convince us that this adjustment should be lower than 3.5 %. See Medtronic I

, at *136. Furthermore, we conclude that an adjustment of this48

[* 48 ] magnitude results in the transaction ’ s not having the same profit potential as defined in Treasury Regulation § 1.482

- 4(c)(2)(iii)(B)( 1 )( ii ). According to respondent’s expert Brian Becker, Pu tnam’s royalty rate
would result in MPROC ’s being six times as profitable as Pacesetter.

Petitioner must show the allocations that it proposes satisfy the
arm’s

- length standard. See Eli Lilly & Co. v. Commissioner , 856 F.2d

at 869 (and the cases cited th ereat)

. We continue to have concerns about petitioner’s use of the CUT method, including the version put forth by

Put nam . His low CUT (calculated at the low end of the range) resulted in a blended wholesale royalty rate of 21.8%

, which is significantly l ower than the blended wholesale royalty rate of 38% concluded in
Medtronic I . The adjustments to the Pacesetter agreement did not
result in a reliable CUT. As in Medtronic I , we are concerned about profit potential and that an adjustment of 3% is not ade quate for know

how. See Medtronic I

, at *127

– 29. Petitioner has not shown that its
allocation meets the arm’s

- length standard required by section 482.

In response to the Court’s questions at the conclusion of the further trial and the posttrial hearing, petitioner changed its focus to its proposed unspecified method. In its P osttrial A nswering B rief petitioner contends that its unspecified method “bridges the gap” because it addresses the Court’s questions about the profitability of its
CRDM and Neuro businesses relative to Pacesetter.

Petitioner recommends two version s of an unspecified method that combines aspects of the CUT with the P acesetter agreement as a comparable and of the CPM. It rejects a n unspecified method averaging
the CUT and the CPM. Petitioner contends further that after considering alternatives there is “no gap to bridge” beyond its unspecified method. For this reason we will not analyze in further detail Putnam’s two proposed royalty rates using the CUT method with adjustmen ts made to the Pacesetter agreement.

D

. Unspecified Method

The 1968 section 482 regulations promulgated three methods, in order of preference: the comparable uncontrolled price method, the resale price method, and the cost plus method

. See Treas. Reg. § 1.482

- 2(e)(1)(ii) (1969) . These regulations provide for another method if none of these three specified methods could “reasonably be applied under the facts and circumstances of a particular case.” Sundstrand Corp. , 96 T.C. at 358 . Courts have approved the use of unspecified49

[* 49 ] methods and referred to these methods as appropriate methods within the context of the regulations. See Eli Lilly & Co. , 84 T.C.

at 1147

– 51; Mornes, Inc. v. Commissioner , T.C. Memo. 1982

- 27, aff’d

, 696 F.2d 1000 (8th Cir. 1982) ; E.I. Du Pont De Nemours & Co. v. United
Sates , 221 Ct. Cl. 333, 350

– 54 (1979)

.

After Congress amended section 4 82 to include the commensurate with income provision, changes were made to the regulations. See Tax
Reform Act of 1986 § 1231(e) (1) . In 1994 Treasury promulgated new regulations that superseded the 1968 regulations. See Treas. Reg. § 1.482

- 1(j)(4) ; T.D. 8 5 52, 1994

- 2 C.B. 9 3

. These regulations replaced the hierarchical approach of the 1968 regulations with the “b est method rule” and provide four permissible methods for determining the arm’s

length result for controlled transfer of intangible property: the CUT method; the CPM; the profit split method; and an “unspecified method” subject to constraints set forth in the regulations. Treas. Reg. § § 1.482

- 1(c)(1 )

, 1.482

- 4(a) ; s ee also Coca

- Cola Co.

, 155 T.C. at 2 1 1

– 12 . There is no strict priority of methods, and no method is considered to be more
reliable than another. Treas

. Reg. § 1.482

- 1(c)(1).

If neither party has proposed a method that constitutes “the best method,” the Court must determine from the record the proper allocation of income. Sundstrand Corp.

, 96 T.C. at 354

. After hearing expert witnesses during further trial and reviewing the parties’ positions, we conclude that there are some benefits to the CUT

, and the Pacesetter agreement is an appropriate c omparable as a starting point

. We are concerned that there is only one comparable

, that adjustments
need to be made , and that if too many adjustments are made, the Pacesetter agreement might cease to be useful even as a starting point.

We reviewed the ad justments made in Medtronic I and c onclude that improvement can be made to the adjustments and that fewer adjustments can be made. Even with making adjustments we further conclude that, to be consistent with the Eighth Circuit’s mandate, the
CUT is not th e best method.

Petitioner originally made an allocation for the devices and lead
licenses based on retail royalty rates of 29% and 15%, respectively. See
Medtronic I

, at *120 . We concluded that these royalty rates were not
arm’s

- length transactions. See id . at *120

– 29 . In Medtronic I we concluded that the wholesale royalty rate for devices was 44% and the
rate for leads was 22%. See id . at *137

– 38 . We made the following
ad justments:50

Adjustment Percentage (in retail)

Starting royalty

rate 17%

Know

- how 7

Profit potential 3.5

Scope of product 2.5

Total 30%

See id. at *137

.

After considering the testimony of petitioner’s expert witnesses McCoy, Cohen, Putnam, and Hubbard, and respondent’s expert
witnesses Heimert and Peter Crosby , we conclude the royalty rate should be the same for devices and leads. We still have the same view
of Heimert’s original CPM as we did in Medtronic I

. See id. at *88

– 119

. Heimert’s CPM is still not the best method, and neither is respondent’s adjusted CPM the best method because of the lack of class III comparables

.

Petitioner proposed an unspecified method that combines
elements of the CUT and the CPM. It provides two versions of this
method

, each consisting of three steps. The first two steps are the same for both versions, and the third step is modified by changing the ratio by which residual profit is allocated between Medtro nic US and MPROC.

The first version include s a 35 % allocation of residual profits to
Medtronic US and a 65% allocation to MPROC (35/65 allocation)

, resulting in a wholesale royalty rate of 35.7%

, and the second version
includes a 50 % allocation of residua l profits to Medtronic US and a 50 %
allocation to MPROC (50/50 allocation) , resulting in a wholesale royalty
rate of 40%. We are concerned that the first version results in a wholesale royalty rate lower that the blended wholesale royalty rate of
38% and the second version is only 2 percentage points higher than 38%.

Relying upon the expert testimony from the further trial, we conclude that the royalty rate in Medtronic I is too low

. W e are still concerned that petitioner’s position does not take into co nsideration [* 50 ]51

[* 51 ] adequately the difference in profit potential between MPROC and the Pacesetter agreement.

Respondent’s expert Heimert testified that it was important for products to have “some leve l of close product similarity ” and that “it is always a matter of degree.” He further testified : “ [W] e want to try to get as close a comparability as we can.” Specifically, regarding the CPM he
testified : “ [W] hat we’re sort of looking at is a blender amalgamation of

returns from many differen t companies in employing a CPM

. . . to smooth out some of these differences. ” He further testified that some comparables are stronger in one are a while other comparables are
weaker in some areas.

During his testimony Heimert suggested using 5 comparab le s instead of 14 as he did in his original report. We are concerned that the remaining f ive companies are not comparable enough to makers of
devices and lead s . He testified that some of the implantable s that are used as comparables are orthopedic parts that do not have “batteries, capacitors, or a heavy degree of software in them” and that would not be “necessarily equivalent.” His testimony also indicated that potential risk to a patient should be considered.

Limiting the comparable companies to five is an improvement; however, the remaining five comparables are not identified as solely class III products. None of the comparable companies makes similar
cardio or neuro devices. Limiting the comparables increases the percentage of profits allocated fro m Medtronic US from 8 % to 12%. We
conclude that a 12% allocation is unreasonable for the same reasons that
we did in Medtronic I

. See Medtronic I

, at *116

– 18

.

Heimert raised concerns that limiting the comparison to only one comparable

, such as Pacesetter, on the basis of function puts aside other
difference s such as distribution. He further testified that by adjusting
the ROA th e royalty rate changes. A higher ROA results in a lower royalty rate

, and vice versa , a lower ROA results in a higher royalty rate.

Heimert testified that a possible way to adjust the profits would be to restrict the set of comparables. He also testified that an adjustment for product liability would increase the ROA. Even though
he be lieves that the Pacesetter agreement was not a reliable CUT, another solution would be to look at adjustments made to the Pacesetter
agreement.52

[* 52 ] The CUT method and the CPM both provide information that helps determine whether a method is the best meth od. The CUT method focuses on price, whereas the CPM focuses on profit benchmark. Respondent’s concerns with the CUT method are that there is not a sufficient level of comparability with the Pacesetter agreement. Petitioner argues that respondent’s CPM uses companies that differ fundamentally from MPROC ; therefore, it fails to take into account the central importance of MPROC

.

Becker’s report include s a table which show s that MPROC was offered a license that required MPROC to perform far less work than Pacesetter. He explained that Pacesetter had 71% of the operating costs, whereas MPROC had 14.8% of the operating costs, which includes cost of components. He further explained that the profit potentials were different, with MPROC ’s having a profit poten tial of 63.6% and the Pacesetter agreement ’s having a profit potential of 29%. He testified that the royalty rates suggested by Putnam and the Court’s O pinion in
Medtronic I w ere “on the right track

. ” His testimony addressed how to bridge the gap

. He testified that “there’s a lot of criticism on both sides ”
and “at the end of the day , the full package of adjustments has to make

some sense. ” Becker further testified the following:

And if he [ referring to Putnam ] came in and said, oh, I did all these adjustments and I came up with 40% or even 35% or even 45%, I would basically say, yeah, I don’t like Dr. Putnam’s logic. They

— I don’t like the logic of it, but ultimately his answer is fine. I don’t reall y have much to say. But that’s not what happened here. So I think with

an eye towards that, there adjustment that, as I recall

, you have made, Dr. Putnam has made , Dr. Berneman has
made . And some of those are not really based on true data.
Some of them are more assumptions and estimates. But if you kind of look at the maximum of some of those, it may get you closer to th is answer that you say, okay, here’s all the potential adjustments, we take the highest of this and the highest of that and see if it get us to a number that’s at
all reasonable

, and then you have, A, your Pacesetter CUT but you also have your CPM as the check and you sort of recover both ways.

Our task is to bridge the gap and find the right adjustments that make sense for this specifi c case. The Court asked about possible methods including averaging the CUT and the CPM. Re sp ondent chose53

[* 53 ] neither to comment on this suggestion nor to make any additional suggestions , except for a comment in respondent’s F inal S upplemental
Posttrial B rief

. 11

E

. Petitioner’s Proposed Unspecified Method

Petitioner’s proposed unspecified method combines aspects of
both the CUT and the CPM. The first step is to apply a modified version of petitioner’s CUT method and the arm ’s

- length wholesale royalty rate of 8% for the trademark license to allocate profits to Medtronic US’s R&D activities. Step two applies a modified ve rsion of respondent’s CPM to allocate profit to MPROC’s activities.

After completi ng the first two steps and allocating a portion of profit for tax years 2005 and 2006, a portion of device and lead system profit remains unallocated. The third step alloca tes the remaining profit
between Medtronic US and MPROC. This step differs from the CUT
method and the CPM

.

For step one, petitioner uses the Pacesetter royalty rate to establish a royalty rate to allocate profits to M edtronic US for its R&D
activities a nd allocates the remaining profits to MPROC. Petitioner

uses r espondent’s CPM to price MPROC’s finished device manufacturing activities using Heimert’s ROA to allocate the corresponding profit to MPROC and allocate the remaining profits to
Medtronic US an d Med USA on the basis of the arm’s

- length prices for component manufacturing and distribution

. The return to MPROC is reduced for profits allocated to Medtronic US and Med USA. In short petitioner proposes to use both the CUT method and the CPM as

start ing points to price MPROC ’s and Medtronic US’s activities , then at step three divides the remaining profit between the two entities using
commercial and economic evidence.

Petitioner contends that a key aspect of its unspecified method is

to address the higher profitability of its devices and lead s compared to the lower profitability of Pacesetter in 1992. The first two steps of the unspecified method do not address profitability. Petitioner describes the third step as a proxy for Medtronic US ’s relatively higher profitability.

11 Respondent’s F inal S upplement al P osttrial B rief includes a chart of wholesale royalty rates, which include a rate using the comparable profit split method based on the adjusted Pacesetter agreement.54

1. Step One

Petitioner starts with Putnam’s propose d adjustments to the Pacesetter agreement. In his expert report Putnam provides two approaches: one using the Pacesetter agreement retail royalty rate of

7% and the other using the maximum 15% retail royalty rate included in the Pacesetter agreement. For calculating step one, the 7% retail royalty rate is used because the maximum 15% retail rate includes an adjustment for profitability. According to petition er t his is unnecessary because step three makes an adjustment for profitability.

Putnam include s low and high ranges in his expert report . For the purposes of the unspecified method, the high

- end range is used. The total retail royalty rate is 17.3%.

Ba se r ate 7.0%

Portfolio access fee 1.8

Cross license 1.0

Know

- how 3.0

C RDM /Neuro avg. sub

- license 4.54

Total r oyalty r ate 12 17.3%

The modified CUT royalty plus the retail rate of 5.4% for the trade
license (wholesale royalty rate of 8%) results in an allocation of $674,352,148 in profits to Medtronic US for 2005 and 2006 for its R&D
activities

.

Unspecified m ethod Med tronic US p rofit for TY 2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit to
allocate $3,333,823,544

Step 1: Modified CUT + t rademark
l icense allocates returns to
Med tronic US $674,352,148

—

12 All rates in chart are retail royalty rates. [* 54 ]55

2. Step Two

Petitioner makes modifications to Heimert’s CPM analysis to
address its concern about the book values used for MPROC’s operati ng assets. The unspecified method makes an upward adjustment to MPROC’s operating assets. Petitioner contends that asset intensi ty allows for a more reliable comparison of asset values and that MPROC’s asset intensity is too low as compared to the 14 comparables in Heimert’s analysis. Asset intensity is equal to operating asset value divided by revenue. Petitioner contends asset intensity is an important metric for comparing MPROC’s book asset values to those of other companies.

The median asset intensity for the five companies that Heimert identified in his testimony is 52%

, and the asset intensity percentage for
MPROC is 13.3%

. Petitioner contends that MPROC’s asset intensity is
too low because of the book value of MPRO C ’s operating assets. It argues that i t s adjustments to asset intensity are support ed by the regulations.

One of the examples provided in the regulations of the C PM method allows for adjustments for asset intensity. See Treas. Reg. § 1. 4 82

- 5(e) ( e xample 5 (ii ) ) . The example allows for each uncontrolled comparable’s assets to be reduced by the amount relative to sales by which they exceed the te sted party’s accounts receivable. See id . The regulations explain that it may be necessary to take into account recent acquisitions, leased assets, intangibles, currency fluctuations

, and other
items that may not be explicitly recorded in the financial s tatements of the tested party or uncontrolled comparable. Id . para. (d)(6)

.

Petitioner further contends that the value of operating assets that MPROC carries on its balance sheet has depreciated over time, and the
book value does not reflect fair market value of the asse t s. It adjusted
MPROC ’ s asset intensity to 52.3%. The results of the adjustment are in
the table below.

Year MPROC average operating assets in Dr.
Heimert’s CPM Adjusted average operating assets with 52.3% asset intensity

2005 $393,029, 644 $1,401,712,258

2006 424,192,500 1,853,316,656 [* 55 ]56

[* 56 ] After making an adjustment for asset intensity, the unspecified method allocates to MPROC profits based on a 41.3% ROA, the average
of ROA s for He i mert’s five companies as applied to MPROC’s adjusted
asset base. This results in the allocation of $1,344,326, 942 in profit to
MPROC for 2005 and 2006 based on the modified CPM . The returns for components and distribution are subtracted from MPROC’s returns.
The table below demonstrates these calculations.

Unspecified m ethod Med tronic US

p rofit for TY

2005

– 06 Med USA

p rofit for TY

2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit
to allocate $3,333,823,544

Step 1: modified CUT +
trademark license allocates
returns to Med tronic US $674,352,148

— —

Step 2(a): modified CPM
allocates returns to MPROC — — $1,344,326,942

Step 2(b):
MPROC payments for
components
and
distribution Components 138,805,027 −138,805,027

Distribution

— $425,697,389 −425,697,389

3. Step Three

T h is final step allocates the remaining overall system profit not allocated in steps one and two, which is explained in the table below.57

[* 57 ]

Unspecified m ethod Med tronic US

p rofit for TY

2005

– 06 Med USA

p rofit for TY

2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit to allocate $3,333,823,544

Step 1: modified CUT +
trademark license allocates
returns to Med tronic US $674,352,148

— —

Step 2(a): modified CPM
allocates returns to
MPROC — — $1,344,326,942

Step 2(b):
MPROC payments for
components
and
distribution Components 138,805,027

— −138,805,027

Distribution

— $425,697,389 −425,697,389

Remaining profit to be
allocated $1,315,144,454

Petitioner has two version s of its unspecified method. For both versions steps one and two are the same. Step three allocates the remaining profits to MPROC and Medtronic US. Petitioner’s first
version allocates 65% of the remaining profit to MPROC and 35% to Medtronic US (65/35 allocations), result ing in 51% of the overall system profit being allocated to Medtronic US and Med USA and 49% to
MPROC

.58

[* 58 ]

Unspecified m ethod with
65/35 residual allocation Med tronic US

p rofit for TY

2005

– 06 Med USA

p rofit for TY

2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit
to allocate $3,333,823,544

Step 1: modified CUT +
trademark license allocates
returns to Med tronic US $674,352,148

— —

Step 2(a): modified CPM
allocates returns to MPROC — — $1,344,326,942

Step 2(b):
MPROC payments for
components
and
distribution Components 138,805,027

— −138,805,027

Distribution

— $425,697,389 −425,697,389

Step 3: allocate remaining profit based on evidence in the
record with 65/35 allocation 460,300,559

— 854,843,395

Total system profit
allocated $1,699,155,123 $1,634,66 7
, 9 21

Petitioner’s second version is a 50

– 50 allocation of the remaining system profit between Medtronic US and MPROC. This version allocates approximately 57% of the system profit to Medtronic US and
Med USA and 43% to MPROC.59

[* 59 ]

Unspecified m ethod with
50/50 residual allocation Med tronic US

p rofit for TY

2005

– 06 Med USA p rofit for TY 2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit to allocate $3,333,823,544

Step 1: modified CUT +
trademark license allocates
returns to Med tronic US $674,352,148

— —

Step 2(b):
MPROC payments for
components
and
distribution Components 138,805,027

— −138,805,027

Distribution

— $425,697,389 −425,697,389

Step 3: allocate remaining profit based on evidence in
the record with 50/50
allocation 657,572,227

— 657,572,227

Total system profit
allocated $1,896,426,791 $1,437,396,753

Version one results in a wholesale royalty rate of 35.7% whereas
version two results in a wholesale royalty rate of 40%.60

[* 60 ]

Royalty r ates for the

u nspecified m ethod Unspecified m ethod

65/35 a llocation Unspecified m ethod

50/50 a llocation

Total profit allocated to
Med tronic US + Med USA $1,699,155,123 $1,896,426,791

Expenses $835,807,413 $835,807,413

Less distribution return −$425,697,389 −$425,697,389

Less component manufacturing return −$138,805,027 −$138,805,027

Gross royalty payment to
Med tronic US $1,970,460,120 $2,167,731,788

Total intercompany sales $4,511,601,171 $4,511,601,171

Total intercompany rate (TM + IP) 43.7% 48.0%

Less trademark intercompany royalty rate −8.0% −8.0%

IP intercompany royalty rate 35.7% 40.0%

Intercompany conversion rate 68% 68%

IP royalty rate 24.3% 27.2%

F

. Analysis of Petitioner’s Proposed Unspecified Method

The regulations require that the same realistic alternatives analysis be performed for both specified and unspecified methods. See Treas. Reg. § 1.482

- 4(d)(1)

. We concluded in Medtronic I that MPROC’s role was “unique” and could be replaced with only “substantial time and
costs.” Medtronic I

, at * 107

– 08 . MPROC had substant ial negotiating leverage to seek a significant portion of the system profits. Respondent relies upon the Court’s conclusion in Co ca

- Cola Co. , 155 T.C. at 254

. T his case is distinguishable from Coca

- Cola because the supply points
in that case “were contra ct manufacturers that performed routine
function s ” and were “easily replaceable.” Id. By contrast in Medtronic I we concluded that MPROC did not perform routine function s

. See
Medtronic I

, at *1 06

– 12

.61

[* 61 ] Respondent errs in relying on the regulations to support a different conclusion. In the example a U.S. company, USbond, licenses intellectual property ( IP ) to its foreign subsidiary, Eurobond. Tre a s. Re g . § 1.482

- 4(d)(2) . Eurobond uses that IP to manufacture and sell an
industrial adhe sive in Europe

. Id

. The royalty rate that USbond charges Eurobond is $100 per ton, and Eurobond charges $550 per ton

to unrelated buyers. Id

. In this example the $100 royalty rate is not arm’s length because USbond could produce and sell the product itself for a profit

. Id

.

Respondent contends that Medtronic US can be compared to
US bond and that Medt ro nic US could have stopped using MPROC an d
instead manufacture d the devices and leads. We have already ruled out
this alternative as being non viable

. See Medtronic I

, at *106

– 08. We remain with our original conclusion that MPRO C could not be easily replaced.

In Medtronic I respondent made the same argument that MPROC was easily replaceable because it performed standard manufacturing activities expected of any manufacturer in the medical device industry. As an example respondent points to petitioner’s Swiss facility. The Swiss facility only m ade devices and could not make enough devices to supply both Europe and the United States. Petitioner never considered outsourcing the activities performed by MPROC because of concerns about quality. Respondent has not provided evidence that disproves ou r initial conclusion that MPROC could not be replaced without
substantial time and costs. See id.

As the royalty rate de crease s , the profits to Medtronic US
de crease. The overall profit split refers to a split of profit when considering the revenues and costs from all of the intercompany
transactions involved in Medtronic US ’ s CRDM and N euro businesses: component manufacturing, distribution, finished manufacturing, and R&D (technology and trademark IP)

. The R&D/MPROC profit refers to the split of profit s between MPROC’s functions and Medtronic US’ s R&D (technology and trademark IP). This profit split subset does not include the allocation of profits with respect to manufacturing and distribution.

The allocation of the remaining profits in step three is a way to adjust the royalty rates without having to make further adjustments to
the CUT. We examine each step of petitioner’s proposed unspecified
method.62

1. Step One

Petitioner’s expert witness Hubbard testified that by using Putnam’s hig h

- end range

, 62 %

– 64% of the profit go es to MPROC and

36 %

– 38% go es to Medtronic US. He thought these profits splits were reasonable. Petitioner relies upon Hubbard’s testimony to support its proposed unspecified method

.

Respondent contends that a 17.3% ret ail royalty rate should not
be used in s tep one of petitioner’s proposed unspecified method. Respondent’s position is that the rate is too low and does not adjust for
all the differences between the MPROC licenses and the Pacesetter agreement. Petitioner contends that the 17.3% rate intentionally excludes any adjustment for differences in profitability to isolate and address differences in profitability in step th r ee. We agree with petitioner that profits should not be addressed in step one because they
are instead addressed in step three.

Petitioner further argues that the adjustment s to royalty rates made in step one are not items that would materially alter the relative split between Medtronic US and MPROC. Petitioner makes the following arguments re garding each of the adjustments to the Pacesetter retail royalty rate. First, the portfolio access fee of 1.8% is accounted for in the early years of the Pacesetter agreement. Second,
the 1% cross

- license adjustment does not affect higher profitability. Third, know

- how is properly accounted for with a 3% adjustment. Fourth, the CRDM / N euro sublicense adjust ment of 4.5% is for a mechanical passthrough of 4.5% of fixed royalties that does not affect the profit split in step three.

In Medtronic I we made an adjustment of 7% for know

- how. See
Medtronic I

, at *137 . Put nam reduced that adjustment 4%. We are not

co nvinced that petitioner’s adjustment is high enough.

Respondent argues that the intellectual property under the
MPRO C licenses is the “crown jewels.” We agree that these were important patents in the cardio and N euro industries; however, we do

not agree with respondent that these patents are crown jewels. Petitioner had licenses with competitors for similar produ cts

. Pacesetter, St. Jude, Guidant, and CPI /Eli Lilly all had access to these patents and were not as profitable as Medtronic US. No patents w ere identified as key patents under the Pacesetter agreement. [* 62 ]63

2. Step Two

We agree with petitioner that an adjustment to asset intensity is

necessary because Heimert’s comparable companies perform functions, have capabilities, and own assets that differ from MPROC ’s

. See id.

at *110 . By increasing MPROC’s asset intensity to make it more comparable to the selected five companies, the comparison of MPROC and the five companies is easier to make ; but the evidence does not support petitioner’s proposed adjustment which increased asset intensity from 13.3% to 52.3%.

Respondent contends that petitioner ’s inflat ing MPROC’s

o perating assets results in a lower allocation to Medtronic US. By increasing asset intensity to 52.3%, petitioner adjusts MPROC’s operation assets by over $1 billion for each year. We disagree with petitioner that depreciation and acquisitions justify th is increase. We agree with respondent’s concerns that MPROC’s revenues are inflated because they include sales attributable to contributions by Medtronic
US and MPROC.

Respondent argues that MPROC should have a lower asset intensity than the comparables because MPROC performs fewer
activities. Pacesetter’s asset intensity of 45.6% is higher than MPROC’s, which is expected because of the different functions that they performed. Heimert’s five comparables used in the modified CPM have asset
intensities be tween 40% and 80%. We agree that the comparables perform more activities than MPROC, but this does not alleviate our concern about the comparability of Heimert’s five comparables.

3. Step Three

Respondent criticize s petitioner’s proposed unspecified meth od for using a 17.3% royalty rate in step one and a 7% royalty rate in step
three . According to respondent

, petitioner use s the 7% Pacesetter royalty rate for determining the residual profit split. Petitioner disagrees with respondent.

Petitioner conten ds that in step three it relie s upon the Pacesetter
agreement to split Pacesetter’s profits under the Pacesetter agreement

, which had a 7% retail royalty rate. According to petitioner

, s tep three does not use the 7% royalty rate as respondent contends. Rather, petitioner use s the 7% royalty rate as part of the evidence to determine
how Medtronic US and Pacesetter split profits as licensor and licensee of technology used in c lass III implantable medical devices. For step [* 63 ]64

[* 64 ] three petitioner wanted to look at how commercial parties with comparable negotiating level s split a given pool of profit.

Petitioner contends that step three does not require a different profit split from that under the Pacesetter agreement because MPROC
also licensed ot her nonpatent rights such as know

- how

, which is compensated by an adjustment in step one. According to petitioner

, s tep three looks at how arm’s

- length parties would split the remaining profit after allocations in steps one and two. Petitioner looked at the portion of Pacesetter’ s profit that Medtronic US expected to receive as a licensor.

According to Robert Pindyck , an expert for petitioner in the prior trial, 22 %

– 23% of the profits went to Medtronic US and 77 %

– 78% of the profits went to Pacesetter. Petitioner contends that step three is focused
on the Medtronic US /Pacesetter profit split for insight into how
Medtron ic US and MPROC

, acting at arm’s length

, would divide the additional profit remaining after steps one and t wo . In other words petitioner believ es that step three should be determined by lo ok ing at
how arm’s

- length commercial actors split the profits arising from the license of technology used in c lass III implantable medical devices. According to petitioner step three relies upon this profit split rather than the royalty rate.

Respondent is critical of step three and believes it has the same problem s as the CUT. Respondent has the same concerns that it had in
Medtronic I and argues that the Pacesetter agreement and the MPROC
licenses do not have the same degree of comparability as required by the regulations. See Treas. Reg. § 1.482

- 1(d)(3)(ii)(A)

.

G. Conclusion

Respondent contends that petitioner’s proposed unspecified method is not commensurate with income as required under section 482
and Treas ury Reg ulation § 1.482

- 4(a) . Respondent’s position is th at Putnam’s CUT “flunks the similar profit potential requirement,” resulting in Medtronic US’ s royalty income from the licensed intangible not being commensurate with income. We agree with respondent that under petitioner’s proposed unspecified method Medtronic US’ s royalty
rate is not commensurate with income.65

H

. Adjustments to Ac hieve Royalty Rate

Respondent contends that petitioner’s proposed unspecified
method “bridges no gaps” between respondent’s CPM and petitioner’s
C UT method . Petition er provides a method which enables the Court to move in the right direction. Respondent provides no suggestion for realistically bridging the gap. Even though we are rejecti ng petitioner’s unspecified method as proposed , we will rely upon petitioner’s methodology as setting forth a framework for determining the royalty
rate for devices and leads.

As we have discussed

, petitioner’s proposed unspecified method is not perfect . Adjustment s need to be made to account for the inadequacy of the CUT method . The major concerns with the CUT
method are that there (1) is only one comparable

, (2) are too many adjustments, and (3) are in adequate adjustments for profit potential.
Petit ioner make s an attempt to address these concerns, but its proposed unspecified method falls short

, and the results do not bridge the gap adequately.

We can start by determining whether a separate rate is needed
for devices and leads and whether it should be adjusted every year. We previously reach ed the conclusion that there can be a single royalty rate which does not need to be adjusted every year.

We agree with petitioner that Putnam’s high

- end range of a 17 % retail royalty can be a starting point. There are not too many adjustments made to reach the 17% rate because we are not relying on petitioner’s proposed method as a CUT method . The adjustmen ts increase the starting retail royalty rate of 7% by 10 percentage points

, and 4.5 are from sublicenses in which the royalty rate is being passed through. We differ with the amount of adjustment for kno w

- how. In
Medtronic I

, at *135

, we acknowledged tha t MPROC had access to the
know

- how of Medtronic US . Pacesetter and its successor St. Jude did not have an ongoing relationship with Medtronic US

. Id

.

During the prior trial petitioner’s expert Ber neman testified that
the Paces etter agreement w as the bes t comparable because it “deal s with the same patents, the same market, the same product, in the same timeframe for the same customers, and the same profit potential.” Id.

at * 133 . The Pacesetter agreement is not ideal, but it is an appropriate starting p oint. [* 65 ]66

[* 66 ] Petitioner’s unspecified method can be used to address prices and profits. No adjustments need to be made to the first two steps. Putnam’s royalty rate is not perfect, but further adjustments would be too speculative. The second step made too high an adjustment for MPROC’s asset intensity. From the expert testimony, we have difficulty pinpointing what adjustments should be made.

T he third step can be adjusted. As petitioner demonstrates with its two versions of the proposed unspecified method, the allocation of the profits between Medtronic US and MPROC can be adjusted and affect the royalty rate. By allocating more of the remain ing profits in s tep

t h ree to Medtronic US

, a higher royalty rate can be achieved

. Step three
is calculated using yearly data so the royalty rate does not need to be adjusted yearly.

After taking into account both parties ’ exper ts’ testimon ies

, we conclud ed that neither party put forth the best method . Our solution may not be perfect, but it reflects a detailed analysis in the context of the Eighth Circuit’s mandate and takes into consideration the level of technology that is needed to make safely the dev ices and leads. It is not
an attempt to create a new method which is simply a hybrid of the CUT
method and the CPM. If respondent had provided a way to make further modifications to the CPM, we would have considered that approach.

The only adjustment th at we are making is in step th r ee by changing the allocation of the remaining profits to Medtronic US and
MPROC. In Medtronic II the Eighth Circuit raised concerns that the Court did not evaluate how the different treatment of intangibles affect s comparability. By making an adjustment

, we account for know

- how and other items that may be directly or indirectly related to the patents
licensed to MPROC. See Medtronic II , 900 F.3d at 615

.

Even though we do not make an adjustment to step two, we
bel ieve that petitioner made to o high an adjustment to MPROC’s ROA. This adjustment resulted in a greater allocation of profit in step two to MPROC than to Medtronic US. By making a greater allocation of the remaining profits in step three to Medtronic US t han to MPROC, we can address our concerns pertaining to step two.

Our adjustment to the third step increases the allocation of remaining profits to Medtronic US. It results in an allocation of 8 0% to
Medtronic US and 2 0% to MPROC (80

– 20 allocation) . Th i s adjustment
is a way of account ing for the imperfections of the CUT method

, such as67

[* 67 ] “know

- how ,” having only one comparable , and differences in profit potential, and imperfections of the CPM, such as the inadequacy of the comparables and an un realisti c profit allocation to MPROC. Additionally, the adjustment takes into account petitioner’s unsupported increase in asset intensity in step two.

Changing the allocation to 8 0

– 2 0 results in a wholesale royalty
rate of 48.8 %.

Unspecified m ethod with
80/20 residual allocation Med tronic US

p rofit for TY

2005

– 06 Med USA

p rofit for TY

2005

– 06 MPROC p rofit for TY 2005

– 06

Device and lead system profit
to allocate $3,333,823,544

Step 1: modified CUT +
trademark license allocates
returns to Med tronic US $674,352,148

— —

Step 2(a): modified CPM
allocates returns to MPROC — — $1,344,326,942

Step 2(b):
MPROC payments for
components
and
distribution Components 138,805,027

— −138,805,027

Distribution

— $425,697,389 −425,697,389

Step 3: allocate remaining profit based on evidence in
the record with 80

– 20
allocation 1,052,115,563

— 263,028,891

Total system profit
allocated $2,290,970,127 $1,042,853,41768

[* 68 ]

Royalty r ates for the u nspecified m ethod Unspecified m ethod

— 80/20
allocation

Total profit allocated to Med tronic US +
Med USA $2,290,970,1277

Expenses $835,807,413

Less distribution return −$425,697,389

Less component manufacturing return −$138,805,027

Gross royalty payment to Med tronic US $2,562,275,124

Total intercompany sales $4,511,601,171

Total intercompany rate (TM + IP) 56.8%

Less trademark intercompany royalty rate −8.0%

IP intercompany royalty rate 48.8%

Intercompany conversion rate 68%

IP royalty rate 33.2%

Overall p rofit s plit

Med tronic US 68.72%

MPROC 31.28%

R&D p rofit s plit

Med tronic US 62.34%

MPROC 37.66%

Increasing the wholesale royalty rate to 48.8 % results in an overall profit split of 6 8 .7 2 % to Medtronic US /Med USA and 3 1. 2 8 % 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’s69

[* 69 ] expert Becker, MPROC had incurred cost s 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 ope rating cost.

The table below shows our resulting wholesale royalty rate of 48.8% in comparison with the wholesale royalty rates under other methods, along with the resulting allocation of profits.70MPROCMedtronicUSR&D/MPROC profit splitMPROCMedtronicUS/MedUSAOverall profit splitWholesaleroyaltyrate[*70]81.6%18.4%67.8%32.2%21.8%PutnamCUT(low)76.4%23.6%63.5%36.5%25.0%BernemanCUT76.1%23.9%63.2%36.8%25.2%MDTpetition63.2%36.8%52.5%47.5%33.1%PutnamCUT(high)59.0%41.0%49.0%51.0%35.7%Unspecified(35–65)55.2%44.8%45.9%54.1%38.0%Tax Court(Medtronic I)53.4%46.6%44.4%55.6%39.1%MOU52.0%48.0%43.2%56.8%40.0%Unspecified(50–50)37.6%62.4%31.3%68.7%48.8%Unspecified(80–20)15.8%84.2%13.1%86.9%62.2%ModifiedCPM15.5%84.5%12.9%87.1%62.4%PacesetterCPSM8.5%91.5%7.0%93.0%66.7%HeimertCPM71

[* 71 ] 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. § 1.48 2

- 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.

In transfer pricing cases it is not unique for the Court to be required to determine the proper transfer pricing method. See Perkin

Elmer Corp. & Subs. v . Commissioner , T.C. Memo. 1993

- 414 ( requiring the Court to find a middle ground without sufficient help from the parties)

. During furthe r trial and posttrial briefs we received suggestions from the parties and their expert witnesses. Our adjustments are premised upon the regulations and expert witness
testimonies.

As respondent’s expert witness Becker suggested, our adjustments start wit h a maximum rate. Petitioner’s proposed unspecified method starts with a rate of 17.3%, which we do not adjust. Including an aspect of the CUT method enables R&D activity to be priced. Including an aspect of the CPM in the unspecified method
enables fin ished device manufacturing to be priced.

Our adjustments consider that the MP R OC 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. B ecause 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 this72

[* 72 ] 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 ble nded 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.

V. Swiss Supply Agreement

Medtronic Europe is a wholly owned, second tier subsidiary of Medtronic US. Medtronic US, MPROC, and Medtronic Europe entered into a sup ply agreement (Swiss Supply Agreement) in which Medtronic Europe agreed to assist MPROC by manufacturing and supplying the U.S. markets with devices necessary to meet customer demand. Medtronic Europe agreed to pay Medtronic US directly an amount equal

to the royalties that MPROC would have paid if it had manufactured
the devices itself and made the sale to Med USA itself.

Respondent increased the amount owed by Medtronic Europe to Medtronic US under the Swiss Supply Agreement. We concluded in
Medtronic I

, at *1 39

, that the issue should be resolved in the same manner as the section 482 issue regarding devices; therefore, the wholesale royalty is 48.8% for devices covered by the Swiss Supply Agreement.

Any contentions we have not addressed are irrelevant, moot, or
meritless.

To reflect the foregoing,

D ecision will be entered under Rule 155

.73

[* 73 ] APPENDIX

Petitioner’s Expert Witnesses

1. Richard Cohen

Dr. Cohen is the Whitaker Professor in Biomedical Engineering

at the Massachusetts Institute of Technology’s (MIT) Institute of Medical Engineering and the Harvard

- MIT Health Sciences and Technology Program. He received his M.D. degree from Harvard
Medica l School and Ph.D. degree in physics from MIT. The Court recognized Dr. Cohen as an expert in the medical device industry.

2. Glenn Hubbard

Dr. Hubbard is the Russell L. Carson Professor in Economics and
Finance in the Graduate School of Business of Colu mbia University. He
is also a p rofessor of e conomics in the Department of Economics of the Faculty of Arts and Sciences at Columbia University. From 2007 to 2017
he was an advis e r to the p resident of the Federal Reserve Bank of New
York. From 2001 to 20 03, he served as Chairman of the President’s
Council of Economic Advis e rs. He received B.A. and B.S. degrees in economics from the University of Central Florida and A.M. and Ph.D. degrees in economics from Harvard University. The Court recognized
Dr. Hub bard as an expert in financial economics.

3. Fred McCoy

Mr. McCoy is p resident and c hief executive o fficer (CEO) of
NeuroTronik Limited. He received his B.S. degree in business administration from the University of North Carolina and his M .B.A

. degree from the Kellogg School of Management at Northwestern University. The Court recognized Mr. McCoy as an expert in the medical device industry.

4. Jonathan Putnam

Dr. Putnam is the founder and principal of Competition Dynamics

, Inc., a litigation and management consulting firm. He has taught at the University of Toronto, Boston University, Columbia University, Yale University, and Vassar College. He received B.A., M.A., and Ph

. D. degrees in economics from Yale University. The Court recognized Dr. Putnam as an expert in the economics of intellectual
property.74

[* 74 ] 5. Christopher Spadea

Mr. Spadea is a senior consultant with Ankura Consulting Group,
LLC

, in the i ntellectual property practice. He is a certified licensing professional. He received a B .S.B.A. degree in f inance from the University of Delaware. The Court recognized Mr. Spadea as an expert in licensing and intellectual property valuation.

Respondent’ s Expert Witnesses

1. Brian Becker

Dr. Becker is president of Precision Economics, LLC. He has taught at John Hopkins University, Marymount University, and George Washington University. He received a B.A. degree in applied
mathematics and economics from Johns Hopkins University and M.A.
and Ph.D. degrees in applied economics from the Wharton School of the University of Pennsylvania. The Court recognized Dr. Becker as an expert in economics with specialization in transfer pricing.

2. Iain Cockburn

Dr. Cockburn is chair of the Strategy and Innovation Department of the Questrom School Business of Boston University. He has also taught at the University of British Columbia and has been a visiting scholar in the Department of Economics at Harv ard University. He
received a B.S. deg ree in economics from Queen Mary College, University of London

, and A.M. and Ph.D. degrees in economics from Harvard University. The Court recognized Dr. Cockburn as an expert
in the economics of innovation and intel lectual property.

3. Peter Crosby

Mr. Crosby has been the CEO of six medical device companies in four countries. He is CEO and managing partner of Biomedical Business Resources, LLC. He received a B.A. degree in electrical engineering and a n M.A. degree in biomedical engineering from the University of Melbourne, A ustralia . The Court recognized Mr. Crosby as an expert in the medical device industry.75

[* 75 ] 4. A. Michael Heimert

Dr. Heimert is a senior advis e r to Duff & Phelps, providing transfer pricing advisory services. He was a professor at Benedictine University. He received a B.S. degree in business economics from Marquette University and M.A. and Ph.D. degrees in economics from the University of Wisconsin

– Milwaukee. The Court recognized

Dr. Heim ert as an expert in economics and transfer pricing.

5. Christine Meyer

Dr. Meyer is an economist and managing director and the chair of the intellectual property practice at National Economic Research
Associate s , Inc. She taught statistics and economics at Bentley College and Colgate University. She received a B.A. degree with a concentration in economics from the U.S. Military Academy and a Ph.D. degree in economics from MIT. The Court recognized Dr. Meyer as an expert in applied microeconomics and in the economic analysis of licenses, patents, and other intellectual property.