United States Tax Court

T.C. Memo. 2022-84

MEDTRONIC, INC. AND CONSOLIDATED SUBSIDIARIES,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent1

—————

Docket No. 6944-11. Filed August 18, 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 FACT 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 Medtronic 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: “The [T]ax [C]ourt determined that the Pacesetter 

agreement was an appropriate [comparable uncontrolled transaction

(CUT)] because it involved similar intangible property and had similar 

circumstances regarding licensing. We conclude that the [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 08/18/22
2

[*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 Siemens Pacesetter, Inc. 

(Pacesetter), and Medtronic US were comparable to the licensing 

agreement between Medtronic US and Medtronic Puerto Rico (MPROC)

and whether the Pacesetter agreement was one created in the ordinary 

course of business; (2) an analysis of the degree of comparability of the 

Pacesetter agreement’s contractual terms and those of the MPROC’s

licensing agreement; (3) an evaluation of how the different treatment of 

intangibles affected the comparability of the Pacesetter agreement and 

the MPROC licensing agreement; and (4) the amount of risk and product 

liability expense that should be allocated between Medtronic US and 

MPROC. 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 Pacesetter 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 length result or whether it made 

proper adjustments under its chosen method.” Id. at 615.

The parties 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 analysis 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 Internal 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 Practice 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, we 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 leads is 

48.8%. Accordingly, the wholesale royalty rate for devices covered by

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.

Medtronic 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, 

petitioner).

Facts of this case were found in our original Opinion, 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 operated 

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 Rico

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 lifesaving 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 agreements under which MPROC 
5

[*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 implanted 

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 device 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, even 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 critical 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 products 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 equipment 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 United States 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 to 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 FDA 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: class 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 are 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 higher 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 safety 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 require 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 devices 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 rigorous, 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 Units

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 through 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 primary 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. Leads 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 the 
8

[*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 abnormally slow 

heart rates. ICDs treat abnormally fast heart rates. ICDs also have 

capacitors as components. CRTs treat insufficient blood flow and 

uncoordinated pumping of the heart’s chambers.

During 2005 and 2006 the device operations at MPROC built 

more than 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 United States. The 40 different 

models of devices comprised approximately 750 individual 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 devices, 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 processes 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 the 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 it 
9

[*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.

Because 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 

procedure 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 delivered

electrical stimulation from neuro devices 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 the 

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 leads 
10

[*10] are attached to specific parts of the spinal 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 specialists, 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 production 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 of 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 specifying, 

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 manufacturing 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 regulatory 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 

Neuromodulation 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 United States 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 acceptable 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 groups 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 liability 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, for 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 

businesses: 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 defibrillators, 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 the 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 agreement 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-year 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 product as:
13

[*13] Section 1.4. Intangible Property

“Intangible 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 all Regulatory Approvals associated with Product.

As specified in the devices and leads agreements, intangible 

property included know-how, which the agreements both defined as:

Section 1.5. Know-How 

“Know-How” shall mean any and all technical information 

presently available or generated during the term of this 

Agreement that relates to Product or Improvements and 

shall include, without limitation, all manufacturing data 

and any other information 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, discoveries, 

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 and 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 “liable 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 highest 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 and 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’slength wholesale royalty of 29% to Medtronic US on MPROC’s U.S. net 

intercompany sales 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. The 

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 royalty 

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 successful, 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 products.

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 sophisticated implantable devices 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 gaining 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-license agreement with 

Eli 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 agreement.

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 

terms 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) terms 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 

agreement 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 approximately $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 Pacesetter 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 tachy 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 

acceptable 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 time 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 originally 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 infringement. Medtronic

US’s board of directors 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 licenses

between Medtronic US and MPROC. 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 competition 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 agreement, 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 one-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 credited against 
18

[*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 on CRDM devices and leads sales in the 

United States and Japan, and a 3.5% royalty on all other international 

sales. Medtronic US 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 Pacesetter 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 Pacesetter 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 the 
19

[*19] terms of the Pacesetter agreement and accepted it in whole, 

including the royalty rate. Per 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 agreement was assigned to St. Jude in its entirety, 

including the maximum rate clause. 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 

included terms, in the event of a sale by Siemens, that Siemens may 

elect to not transfer its rights under the Pacesetter agreement. The 

Pacesetter agreement included terms that provided a formula to 

calculate a payment for buying the remaining royalty obligations.

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 effect 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 sales 

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. Reflecting 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 significant 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 careful 

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 implantable 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 litigation 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 litigation. 

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 

provided 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 Deficiency

In an audit of petitioner’s 2002 tax return, respondent analyzed 

the devices and leads intercompany transactions and the transfer prices 

among MPROC, Medtronic US, and Med USA, as well as the 2002 
21

[*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 reflect agreements reached in an 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 respondent’s expert A. Michael Heimert, 

explained in greater detail below, which used the CPM. On July 10, 

2014, respondent amended his Answer to exclude royalty amounts paid 

by MPROC for non-U.S. sales, asserting that his adjustments under 

section 482 were 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. We focus on the degree to which experts’ 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. 

Petitioner 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 use 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 flawed 

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,” referring 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 related 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 terms 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, the regulations provide four methods to determine the arm’slength 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 method rule provides that the arm’slength result of a controlled transaction must be determined using the 

method that, under the facts and circumstances, provides 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 factors 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 circumstances. 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 nature 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 would 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’slength result for the controlled transfer 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 or 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 combined 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 method is derived from the combined operating profit of 

uncontrolled taxpayers whose transactions and activities are similar to 
25

[*25] those of the controlled taxpayers in the relevant business. Id.

subpara. (2).

D. Unspecified Method

Methods not specified in paragraphs (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 alternatives 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 

by 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 with 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 commensurate with the income attributable to the intangible.” 

Tax Reform 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 change, 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 manufacturing 

or assembly costs. . . .

. . . .

Many observers have questioned the effectiveness of 

the “arm’s length” approach of the regulations under 
26

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 vary. 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 greater 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 other 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, such 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 respect.

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 

conducted 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 

standard. 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 intangible.

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) para. 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 Court 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 pursuant to the Eighth Circuit’s 

mandate:

(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 analysis of the degree of comparability of the 

Pacesetter agreement’s contractual terms and those of the 

[MPROC] licensing agreement;

[*28]
29

(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 CPM, including which method is the 

best method.

This 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 Is 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’slength 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 

particularly 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 the 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 

profit 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 modifications

of the intangible; (4) the uniqueness of the property; (5) the duration of 

the license; (6) any economic and product liability risks; (7) the existence 

and extent 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 reliability of 

assumptions used. Id. subdivs. (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 must 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 an analysis 

that looks at the functions of the two transactions such as R&D; product 

design and engineering; manufacturing; product fabrication; purchasing 

and materials 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 

determine 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% and 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 CRDM 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 agreements 

cannot be comparable because of the different types of relationships.

The section 482 arm’s-length standard is premised on the 

principle 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. § 1.482-4(c)(4) (examples 1 and 3). We disagree with 

respondent’s position that the Pacesetter agreement and the MPROC 

licenses cannot be comparable because a transaction with a vertical 

relationship and one with a horizontal relationship are being compared.

Even though we disagree 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.

Respondent 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 difference 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 million 
32

[*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 agreement does not include Neuro 

products. This 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 agreement 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,

whereas the Pacesetter agreement licensed 342 patents. Accordingly, 

we conclude that the products licensed are not similar.

Furthermore, the determination of whether the products and 

services are considered comparable is similar to the determination of 

whether 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 about 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 we 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 Pacesetter Agreement as a CUT

Petitioner contends that appropriate adjustments may be made 

to the Pacesetter agreement and that the Pacesetter agreement with 

appropriate adjustments remains a CUT. Petitioner’s expert Jonathan 

Putnam made adjustments to the CUT and 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 adjustments in Medtronic I. The major difference is the 
33

[*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 *138.

Respondent’s position is that 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 compounds the chances of 

error.

In the light of the Eighth 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 Between Pacesetter and 

Medtronic US Were Comparable to the Licensing 

Agreement Between Medtronic US and MPROC and 

Whether the Pacesetter Agreement Was an Agreement 

Created in the Ordinary Course of Business

Treasury Regulation § 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.” 

Treasury Regulation § 1.482-1(d)(4)(iii)(B) (example 1) provides an 

example of a transaction not in the ordinary course of business. In this

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 business.

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 Christopher 

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 doubt on, a patent’s value. Putnam 

testified that “litigation actually helps us draw better inferences about 
34

[*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 negotiations 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 acquisition 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 cost an additional $17 

million. The expected cashflow of the license to Pacesetter 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.

Putnam 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 parties 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 licensee’s 

profit-motivated evaluation of that compulsion exists whether actual 

litigation exists or not and that these evaluations 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 crosslicenses 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 success 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 better 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 products 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 business 

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 Analysis 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 payments are comparable. See Treas. Reg. 

§ 1.482-4(c)(2)(iii). Both agreements had running royalty rates based 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 claims 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 claims 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 payment 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 among 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 between 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 Medtronic 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. Hubbard 

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 Included 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 were negotiated. 

Medtronic US never designated any patents as key patents. This 

inaction 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. The 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 supra Section III.A.

F. An Analysis That Contrasts and Compares the CUT 

Method Using the Pacesetter Agreement with or Without 

Adjustments and the CPM, Including Which Method Is the 

Best

Under the CUT method, controlled and uncontrolled transactions 

must involve the same or comparable intangible 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 comparability of

circumstances between a controlled and an uncontrolled transaction for 

the CUT method. See id. subdiv. (iii)(B)(2). These factors were 
38

[*38] discussed supra Section III.A., and we concluded that the general 

comparability factors were not met and the circumstantial 

comparability factors need not be considered.

In the Court’s previous Opinion we found that the royalty rates 

petitioner proposed are not arm’s length because appropriate 

adjustments 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 Pacesetter 

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 that using the Pacesetter 

agreement as a CUT results in MPROC’s receiving the “lion’s share” of 

profits earned from the sales of CRDM and Neuro products. This line of 

argument raises the question of why MPROC’s profitability dwarfs that 

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 217–18. The nature of the assets 

owned and the activities 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 specifications 

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 sweetened beverages 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 products. 

Medtronic I, at *106–08.
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. Respondent 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 opinion that petitioner met its burden of showing 

that respondent’s allocations were arbitrary and capricious. 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 party 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 concludes 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 profits 

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 estimates 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 risk to patients but differ from class III devices, which sustain 

or support life. Hubbard explained that a company that largely 
40

[*40] produces elastic bandages is unlikely to be comparable to a 

company that largely produces implantable pacemakers, even though 

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 

differences 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 comparables in Medtronic I. See Medtronic I, at *109–12. In 

the light of the Eighth Circuit’s mandate we have reexamined the CPM 

method 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 requires too many 

adjustments, and the CPM results in an unrealistic profit split and too 

high a royalty rate. Therefore, we conclude neither 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. Respondent contends that 

product liability risk 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 regulations “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 bear 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 assumption that MPROC bore all product 

liability costs for CRDM and Neuro products. According to respondent’s 

expert from the prior trial Paul Braithwaite the ultimate claimed costs 

for injuries and related legal expenses were $25.2 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 MPROC during 2005 

and 2006 was between $220 million and $235 million for 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 standards. 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 costs of $117 million of the $205 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 entered 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 costs associated with prior recalls. We are not 
42

[*42] convinced by the evidence that respondent’s adjustment is enough 

to account for MPROC’s role regarding product liability claims.

IV. Best Method

A. Introduction

In Medtronic I we reviewed respondent’s section 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 Circuit 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 particular 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 the 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% trademark 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 adjustments to account for product liability. These 

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% for 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, capricious, or unreasonable. See Sundstrand 

Corp., 96 T.C. at 353 (first citing G.D. Searle & Co. v. Commissioner, 88 

T.C. 252, 358 (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 respondent 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 Co. v. 

Commissioner, 56 T.C. 961, 971 (1971).

The modified CPM results in retail royalty rates 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. The 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 royalty 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 class III medical device 

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 devices, 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 five 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 

several 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 comparables to result in 

the CPM’s being the best method.

Hubbard explained that MPROC focused exclusively on 

manufacturing finished medical devices, specifically class 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 comparables 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 profitability. He disagreed with 

Heimert’s position that narrowing the set of comparables to the 
45

[*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 (including Greatbatch) is 40.4% 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 determining 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 quality of the data and assumptions used in the 

analysis. Treas. 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 pureplay 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 from finished medical 

device manufacturing. 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 to MPROC’s revenues of 

approximately $2 billion in 2005.9 Stryker and Zimmer had over double 

MPROC’s revenues whereas Wright Medical Group and Orthofix had

less than 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 with 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 problems 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 quality 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 his 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 allocations 

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’slength 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 its position that the CUT 

is the best method and that the Pacesetter agreement is a valid CUT.

Putnam offered two approaches adjusting the royalty rate, and 

for both approaches he estimated low and high rates. 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 22.3% and 33.4% for cardio and 17.9% and 27.5% for Neuro. 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 Neuro. 

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’ financial 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 account 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 this 
48

[*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, Putnam’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 thereat). We continue to have concerns about 

petitioner’s use of the CUT method, including the version put forth by 

Putnam. His low CUT (calculated at the low end of the range) resulted 

in a blended wholesale royalty rate of 21.8%, which is significantly lower 

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 adequate for knowhow. 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 Posttrial Answering Brief 

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 versions of an unspecified method 

that combines aspects of the CUT with the Pacesetter agreement as a 

comparable and of the CPM. It rejects an 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 

adjustments 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 unspecified
49

[*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 482 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. 8552, 1994-2 C.B. 93. These regulations replaced 

the hierarchical approach of the 1968 regulations with the “best method 

rule” and provide four permissible methods for determining the arm’slength 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); see also Coca-Cola Co., 155 T.C. at 211–12. 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 comparable 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 adjustments made in Medtronic I and conclude

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 the 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 

adjustments:
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 Medtronic US and MPROC.

The first version includes 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 residual 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. We are still 

concerned that petitioner’s position does not take into consideration 

[*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 level 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 different companies in employing a CPM . . . to 

smooth out some of these differences.” He further testified that some 

comparables are stronger in one area while other comparables are 

weaker in some areas. 

During his testimony Heimert suggested using 5 comparables

instead of 14 as he did in his original report. We are concerned that the 

remaining five companies are not comparable enough to makers of 

devices and leads. He testified that some of the implantables 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 from 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 

differences such as distribution. He further testified that by adjusting 

the ROA the 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 believes 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 method. 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 includes a table which shows 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 potential 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 Opinion in 

Medtronic I were “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 really 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 this 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 specific case. The Court asked about possible 

methods including averaging the CUT and the CPM. Respondent chose 
53

[*53] neither to comment on this suggestion nor to make any additional 

suggestions, except for a comment in respondent’s Final Supplemental 

Posttrial Brief.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 version of respondent’s

CPM to allocate profit to MPROC’s activities.

After completing 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 allocates 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 Medtronic US for its R&D 

activities and allocates the remaining profits to MPROC. Petitioner 

uses respondent’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 and 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 

starting 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 leads 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 Final Supplemental Posttrial Brief 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 proposed 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 petitioner this is unnecessary 

because step three makes an adjustment for profitability.

Putnam includes 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%.

Base rate 7.0%

Portfolio access fee 1.8

Cross license 1.0

Know-how 3.0

CRDM/Neuro avg. sub-license 4.54

 Total royalty rate12 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 method Medtronic US profit 

for TY 2005–06

MPROC profit 

for TY 2005–06

Device and lead system profit to 

allocate $3,333,823,544

Step 1: Modified CUT + trademark 

license allocates returns to 

Medtronic 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 operating 

assets. The unspecified method makes an upward adjustment to 

MPROC’s operating assets. Petitioner contends that asset intensity 

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 MPROC’s operating assets. It 

argues that its adjustments to asset intensity are supported by the 

regulations.

One of the examples provided in the regulations of the CPM

method allows for adjustments for asset intensity. See Treas. Reg. 

§ 1.482-5(e) (example 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 tested 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 statements 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 assets. 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 ROAs for Heimert’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 method

Medtronic US 

profit for TY 

2005–06

Med USA 

profit for TY 

2005–06

MPROC profit 

for TY 2005–06

Device and lead system profit 

to allocate $3,333,823,544

Step 1: modified CUT + 

trademark license allocates 

returns to Medtronic 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

This 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 method

Medtronic US 

profit for TY 

2005–06

Med USA 

profit for TY 

2005–06

MPROC profit 

for TY 2005–06

Device and lead system 

profit to allocate $3,333,823,544

Step 1: modified CUT + 

trademark license allocates 

returns to Medtronic 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 versions 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), resulting in 51% of the overall system 

profit being allocated to Medtronic US and Med USA and 49% to 

MPROC.
58

[*58]

Unspecified method with 

65/35 residual allocation

Medtronic US 

profit for TY 

2005–06

Med USA 

profit for TY 

2005–06

MPROC profit 

for TY 2005–06

Device and lead system profit 

to allocate $3,333,823,544

Step 1: modified CUT + 

trademark license allocates 

returns to Medtronic 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 $1,634,667,921

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 method with 

50/50 residual allocation

Medtronic US 

profit for TY 

2005–06

Med USA profit 

for TY 2005–06

MPROC profit 

for TY 2005–06

Device and lead system 

profit to allocate $3,333,823,544

Step 1: modified CUT + 

trademark license allocates 

returns to Medtronic 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 rates for the 

unspecified method

Unspecified method 

65/35 allocation

Unspecified method 

50/50 allocation

Total profit allocated to 

Medtronic 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 

Medtronic 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 substantial negotiating 

leverage to seek a significant portion of the system profits. Respondent 

relies upon the Court’s conclusion in Coca-Cola Co., 155 T.C. at 254. 

This case is distinguishable from Coca-Cola because the supply points 

in that case “were contract manufacturers that performed routine 

functions” and were “easily replaceable.” Id. By contrast in Medtronic I

we concluded that MPROC did not perform routine functions. See

Medtronic I, at *106–12.
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. Treas. 

Reg. § 1.482-4(d)(2). Eurobond uses that IP to manufacture and sell an 

industrial adhesive 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 

USbond and that Medtronic US could have stopped using MPROC and 

instead manufactured the devices and leads. We have already ruled out

this alternative as being nonviable. See Medtronic I, at *106–08. We 

remain with our original conclusion that MPROC 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 made 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 our 

initial conclusion that MPROC could not be replaced without 

substantial time and costs. See id.

As the royalty rate decreases, the profits to Medtronic US 

decrease. 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 Neuro businesses: 

component manufacturing, distribution, finished manufacturing, and 

R&D (technology and trademark IP). The R&D/MPROC profit refers to 

the split of profits 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 high-end range, 62%–64% of the profit goes to MPROC and 

36%–38% goes 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% retail royalty rate should not 

be used in step 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 three. 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 adjustments 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 regarding 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/Neuro sublicense adjustment 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. Putnam reduced that adjustment 4%. We are not 

convinced that petitioner’s adjustment is high enough.

Respondent argues that the intellectual property under the 

MPROC licenses is the “crown jewels.” We agree that these were 

important patents in the cardio and Neuro industries; however, we do 

not agree with respondent that these patents are crown jewels. 

Petitioner had licenses with competitors for similar products. 

Pacesetter, St. Jude, Guidant, and CPI/Eli Lilly all had access to these

patents and were not as profitable as Medtronic US. No patents were 

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 inflating MPROC’s 

operating 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 this 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 between 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 criticizes petitioner’s proposed unspecified method 

for using a 17.3% royalty rate in step one and a 7% royalty rate in step 

three. According to respondent, petitioner uses the 7% Pacesetter 

royalty rate for determining the residual profit split. Petitioner 

disagrees with respondent.

Petitioner contends that in step three it relies upon the Pacesetter 

agreement to split Pacesetter’s profits under the Pacesetter agreement,

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

does not use the 7% royalty rate as respondent contends. Rather,

petitioner uses 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 class III implantable medical devices. For step 

[*63]
64

[*64] three petitioner wanted to look at how commercial parties with 

comparable negotiating levels 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 other nonpatent rights such as know-how, which is 

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

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 

Medtronic US and MPROC, acting at arm’s length, would divide the 

additional profit remaining after steps one and two. In other words 

petitioner believes that step three should be determined by looking at 

how arm’s-length commercial actors split the profits arising from the 

license of technology used in class 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 

problems 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 Treasury Regulation § 1.482-4(a). Respondent’s position is that

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 Achieve Royalty Rate

Respondent contends that petitioner’s proposed unspecified 

method “bridges no gaps” between respondent’s CPM and petitioner’s 

CUT method. Petitioner 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 rejecting 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. Adjustments 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 inadequate adjustments for profit potential. 

Petitioner makes 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 reached 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 adjustments 

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 know-how. In 

Medtronic I, at *135, we acknowledged that 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 Berneman testified that 

the Pacesetter agreement was the best comparable because it “deals

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 point.

[*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.

The 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 remaining profits in step 

three 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’ experts’ testimonies, we 

concluded 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 devices 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 that we are making is in step three 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 affects

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 

believe that petitioner made too 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 than 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 80% to 

Medtronic US and 20% to MPROC (80–20 allocation). This adjustment 

is a way of accounting for the imperfections of the CUT method, such as 
67

[*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 unrealistic profit allocation to MPROC. 

Additionally, the adjustment takes into account petitioner’s 

unsupported increase in asset intensity in step two.

Changing the allocation to 80–20 results in a wholesale royalty 

rate of 48.8%.

Unspecified method with 

80/20 residual allocation

Medtronic US 

profit for TY 

2005–06

Med USA 

profit for TY 

2005–06

MPROC profit 

for TY 2005–06

Device and lead system profit 

to allocate $3,333,823,544

Step 1: modified CUT + 

trademark license allocates 

returns to Medtronic 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 $1,042,853,417
68

[*68]

Royalty rates for the unspecified method Unspecified method—80/20

allocation

Total profit allocated to Medtronic 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 Medtronic 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 profit split

Medtronic US 68.72%

MPROC 31.28%

R&D profit split

Medtronic US 62.34%

MPROC 37.66%

Increasing the wholesale royalty rate to 48.8% results in an 

overall profit split of 68.72% to Medtronic US/Med USA and 31.28% 

profit split to MPROC and a R&D profits split of 62.34% to Medtronic 

US and 37.66% to MPROC. The resulting profit split reflects the 

importance of the patents as well as the role played by MPROC. The 

profit split is more reasonable than the profit split of 56.8% to Medtronic 

US/Med USA and 43.2% to MPROC resulting from petitioner’s 

unspecified method with a 50–50 allocation. According to respondent’s 
69

[*69] expert Becker, MPROC had incurred costs of 14.8% of retail prices. 

The evidence does not support a profit split which allocates 43.2% of the 

profits to MPROC when it has only 14.8% of the operating cost.

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.
70

MPROC

Medtronic 

US

R&D/MPROC profit split

MPROC

Medtronic

US/Med 

USA

Overall profit split

Wholesale 

royalty 

rate

[*70]

81.6%18.4%67.8%32.2%21.8%

Putnam 

(low)

CUT 

76.4%23.6%63.5%36.5%25.0%

Berneman 

CUT

76.1%23.9%63.2%36.8%25.2%

MDT 

petition

63.2%36.8%52.5%47.5%33.1%

Putnam 

CUT 

(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%

MOU

52.0%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%

Modified 

CPM

15.5%84.5%12.9%87.1%62.4%

Pacesetter 

CPSM

8.5%

91.5%

7.0%

93.0%66.7%

Heimert 

CPM
71

[*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. § 1.482-1(c)(1). We have concluded previously 

that petitioner’s CUT method, petitioner’s proposed unspecified method, 

the Court’s adjusted CUT method in Medtronic I, respondent’s CPM, 

and respondent’s modified CPM do not result in an arm’s-length royalty 

rate and are not the best method. Only petitioner suggested a new 

method, its proposed unspecified method; however, for reasons 

previously explained, that method needed adjustment for the result to 

be arm’s length.

In transfer pricing cases it is not unique for the Court to be 

required to determine the proper transfer pricing method. See PerkinElmer Corp. & Subs. v. Commissioner, T.C. Memo. 1993-414 (requiring 

the Court to find a middle ground without sufficient help from the 

parties). During further 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 with 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 finished device manufacturing to be priced.

Our adjustments consider that the MPROC licenses are valuable 

and earn higher profits than the licenses covered by the Pacesetter 

agreement. We also looked at the ROA in the Heimert analysis and from 

the evidence cannot determine what the proper ROA should be. The 

criticisms each party had of the other’s methods were factored into our 

adjustment. Respondent’s expert Becker testified that you may not like 

the logic of a method but ultimately the answer is fine. Because neither 

petitioner’s proposed CUT method nor respondent’s modified CPM was 

the best method, our goal was to find the right answer. The facts in this 
72

[*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 blended wholesale royalty rate of 

21.8%; whereas respondent’s expert Heimert’s original CPM analysis 

resulted in a blended wholesale royalty rate of 67.7%. In Medtronic I we 

concluded that the blended wholesale royalty rate was 38%, and after 

further trial, we conclude that the wholesale royalty rate is 48.8%, which 

we believe is the right answer.

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 supply 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 *139, 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,

Decision 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 

Medical 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 Columbia University. He 

is also a professor of economics in the Department of Economics of the 

Faculty of Arts and Sciences at Columbia University. From 2007 to 2017 

he was an adviser to the president of the Federal Reserve Bank of New 

York. From 2001 to 2003, he served as Chairman of the President’s 

Council of Economic Advisers. 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. Hubbard as an expert in financial economics.

3. Fred McCoy

Mr. McCoy is president and chief executive officer (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 intellectual property practice. He is a certified licensing 

professional. He received a B.S.B.A. degree in finance 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 Harvard University. He 

received a B.S. degree 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 intellectual 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 an M.A. degree in biomedical engineering from the 

University of Melbourne, Australia. The Court recognized Mr. Crosby 

as an expert in the medical device industry.
75

[*75] 4. A. Michael Heimert

Dr. Heimert is a senior adviser 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. Heimert 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 

Associates, 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.