Court Opinion

ID: 7802256
Source: CourtListenerOpinion
Date Created: 2022-08-22 00:01:27.21869+00
Date Added: 2024-06-11T16:29:25.881412
License: Public Domain

United States Tax Court

                              T.C. Memo. 2022-84

     MEDTRONIC, INC. AND CONSOLIDATED SUBSIDIARIES,
                         Petitioner
                             v.
          COMMISSIONER OF INTERNAL REVENUE,
                       Respondent 1

                                    —————

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

[*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%.
                                    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 life-
saving or life-sustaining class III medical devices, as defined and
determined by the Food and Drug Administration (FDA). Medtronic US
and MPROC entered into license 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

[*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
                                    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

[*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’s-
length 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-
                                   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’s-
length amount to be charged in a controlled transfer of intangible
property: the CUT method, the CPM, the profit split method, and
unspecified methods as described in Treasury Regulation § 1.482-4(d).
See id. § 1.482-4(a). 6 The best method rule provides that the arm’s-
length 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’s-
length 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

[*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. . . .

            ....
                                    27

[*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
                                  28

[*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;
                                   29

[*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’s-
length standard. The result in Medtronic I was not the first time this
Court approved the CUT method to measure arm’s-length prices for
intercompany transfers of intangibles. See Veritas Software, 133
T.C. 297. A comparable with different royalty rate may serve “as a base
from which to determine the arm’s-length consideration for the
intangible property involved in this case.” Sundstrand Corp. & Subs. v.
Commissioner, 96 T.C. 226, 393 (1991).

       The degree of comparability between controlled and uncontrolled
transactions is determined by applying the comparability provisions of
Treasury Regulation § 1.482-1(d); however, specified factors are
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
                                    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 cross-
licenses in the cardio device industry. He explained that the experience
in the industry was that patents were potent weapons that could enable
the patent holder to delay a company from introducing an important
feature or product critical to commercial 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 pure-
play implantable medical device manufacturers. Two of the five were
engaged in R&D, component manufacturing, and distribution, in
addition to finished medical device manufacturing. The other three
were involved in R&D and distribution, aside 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’s-
length 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 know-
how. See Medtronic I, at *127–29. Petitioner has not shown that its
allocation meets the arm’s-length standard required by section 482.

       In response to the Court’s questions at the conclusion of the
further trial and the posttrial hearing, petitioner changed its focus to its
proposed unspecified method.         In its 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’s-
length result for controlled transfer of intangible property: the CUT
method; the CPM; the profit split method; and an “unspecified method”
subject to constraints set forth in the regulations. Treas. Reg. §§ 1.482-
1(c)(1), 1.482-4(a); 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

[*50]              Adjustment           Percentage (in
                                            retail)

             Starting royalty               17%
             rate

             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
                                    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

[*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 rate 12                   17.3%

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

                                                 Medtronic US profit     MPROC profit
              Unspecified method
                                                  for TY 2005–06        for TY 2005–06

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

 Step 1: Modified CUT + trademark
 license allocates returns to                        $674,352,148             —
 Medtronic US

        12   All rates in chart are retail royalty rates.
                                        55

[*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.

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

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

 2006              424,192,500                  1,853,316,656
                                          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.

                                    Medtronic US     Med USA
                                                                      MPROC profit
      Unspecified method            profit for TY   profit for TY
                                                                     for TY 2005–06
                                      2005–06         2005–06

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

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

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

 Step 2(b):
 MPROC               Components       138,805,027                      −138,805,027
 payments for
 components
 and                 Distribution        —          $425,697,389       −425,697,389
 distribution

                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]

                               Medtronic US       Med USA
                                                                  MPROC profit
     Unspecified method        profit for TY     profit for TY
                                                                 for TY 2005–06
                                 2005–06           2005–06

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

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

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

 Step 2(b):     Components
 MPROC                            138,805,027         —            −138,805,027
 payments for
 components
 and            Distribution
                                    —             $425,697,389     −425,697,389
 distribution

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

       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]

                                   Medtronic US     Med USA
   Unspecified method with                                           MPROC profit
                                   profit for TY   profit for TY
   65/35 residual allocation                                        for TY 2005–06
                                     2005–06         2005–06

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

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

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

 Step 2(b):        Components        138,805,027        —             −138,805,027
 MPROC
 payments for      Distribution
 components
                                        —          $425,697,389       −425,697,389
 and
 distribution

 Step 3: allocate remaining
 profit based on evidence in the     460,300,559        —              854,843,395
 record with 65/35 allocation

  Total system profit
                                          $1,699,155,123            $1,634,667,921
  allocated

       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]

                               Medtronic US
  Unspecified method with                      Med USA profit     MPROC profit
                               profit for TY
  50/50 residual allocation                    for TY 2005–06    for TY 2005–06
                                 2005–06

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

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

Step 2(b):      Components     138,805,027               —       −138,805,027
MPROC
payments for
components
and             Distribution
                                    —            $425,697,389    −425,697,389
distribution

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

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

      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
        unspecified method         65/35 allocation     50/50 allocation

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

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

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

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

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

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

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

 Less trademark intercompany
                                        −8.0%                −8.0%
 royalty rate

 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

[*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.
                                    63

[*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
                                   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

[*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.
                                   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%.

                                 Medtronic US     Med USA
 Unspecified method with                                           MPROC profit
                                 profit for TY   profit for TY
 80/20 residual allocation                                        for TY 2005–06
                                   2005–06         2005–06

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

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

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

 Step 2(b):       Components       138,805,027        —             −138,805,027
 MPROC
 payments for     Distribution
 components
                                      —          $425,697,389       −425,697,389
 and
 distribution

 Step 3: allocate remaining
 profit based on evidence in
                                 1,052,115,563        —              263,028,891
 the record with 80–20
 allocation

  Total system profit
                                        $2,290,970,127            $1,042,853,417
  allocated
                                         68

[*68]

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

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

 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]       Putnam
                          Berneman    MDT
                                                Putnam
                                                          Unspecified       Tax Court              Unspecified   Unspecified   Modified   Pacesetter   Heimert
                  CUT                             CUT                                      MOU
                            CUT      petition              (35–65)         (Medtronic I)            (50–50)       (80–20)       CPM        CPSM         CPM
                  (low)                          (high)
     Wholesale
      royalty    21.8%     25.0%     25.2%      33.1%       35.7%             38.0%        39.1%     40.0%         48.8%       62.2%       62.4%       66.7%
       rate
                                                                        Overall profit split
     Medtronic
      US/Med     32.2%     36.5%     36.8%      47.5%       51.0%             54.1%        55.6%     56.8%         68.7%       86.9%       87.1%       93.0%
       USA
70

     MPROC       67.8%     63.5%     63.2%      52.5%       49.0%             45.9%        44.4%     43.2%         31.3%       13.1%       12.9%        7.0%
                                                                 R&D/MPROC profit split
     Medtronic
                 18.4%     23.6%     23.9%      36.8%       41.0%             44.8%        46.6%     48.0%         62.4%       84.2%       84.5%       91.5%
       US
      MPROC      81.6%     76.4%     76.1%      63.2%       59.0%             55.2%        53.4%     52.0%         37.6%       15.8%       15.5%        8.5%
                                   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 Perkin-
Elmer Corp. & Subs. v. Commissioner, T.C. Memo. 1993-414 (requiring
the Court to find a middle ground without sufficient help from the
parties).   During 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.