The Tax Cuts And Jobs Act May Breathe New Life Into Implied Intangible Transfer Claim

By Ryan Finley

At the end of the Tax Court’s 2016 opinion in Medtronic, a short section briefly summarizes and summarily rejects what the opinion describes as the IRS’s “alternative allocation under section 367(d).”

A similarly perfunctory assessment appears tucked away in the Tax Court’s 2017 opinion in Eaton, which rejects substantially the same alternative argument for the same reasons, often using almost exactly the same language.

This alternative argument, according to which acceptance of the taxpayer’s transfer pricing method implies that there must have been an intangible transfer subject to section 367(d), has received relatively little attention.

This likely reflects the IRS’s failure to date to successfully make the argument, the agency’s decision to prioritize its section 482 position, and the alternative argument’s absence from the government’s Medtronic and Eaton appellant briefs.

However, its skeptical reception in Medtronic, T.C. Memo. 2016-112, and Eaton, T.C. Memo. 2017-147, does not condemn the argument to perpetual irrelevance, especially for disputes involving tax years subject to the Tax Cuts and Jobs Act.

Plucking Value From Thin Air

When it appears, the IRS’s implied intangible transfer argument serves as a fallback behind a primary claim that the comparable profits method should have been used to price a transaction between one or more domestic members of a U.S.-based multinational group and a low-taxed subsidiary located offshore.

As long as the low-taxed subsidiary can be used as the tested party, the CPM is the IRS’s natural method of choice in this scenario because it restricts the amount of profit that can be allocated offshore.

After assigning some fixed return for the tested party as a percentage of sales, costs, or assets, the CPM allocates all residual returns to the other party by default. Pricing a U.S. parent company’s license of valuable intangibles to a low-taxed foreign subsidiary using the CPM, and using the subsidiary as the tested party, thus prevents the allocation of any intangible-related residual returns to the low-tax jurisdiction.

U.S.-based multinationals like Medtronic and Eaton with low-taxed subsidiaries naturally tend to prefer other methods, especially the comparable uncontrolled transaction method, which can offer their subsidiaries a share of residual returns.

Alleging flaws in the IRS’s selection of the tested party often plays a key role in taxpayers’ attempts to downgrade the reliability of the CPM relative to the CUT method. As noted in reg. section 1.482-5(b)(2)(i), “in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.”

Accordingly, taxpayers involved in these types of disputes often argue that their low-taxed foreign subsidiary’s ownership of unique and valuable intangibles disqualifies its selection as the tested party and renders the CPM unreliable as a result.

Although the IRS devotes most of its efforts in these disputes to defending its selection of the CPM by challenging taxpayers’ inflated characterizations of their tax-favored subsidiaries, the IRS’s alternative section 367(d) argument turns those characterizations against the taxpayer.

If the foreign subsidiary, which in Medtronic and Eaton owned no significant self-developed intangibles, is too complex to be the tested party in a CPM analysis, then it must have acquired the intangibles necessary to justify its high returns at some point, the argument goes.

In Medtronic, that point was when the two U.S. subsidiaries that oversaw the group’s Puerto Rican manufacturing operations until 2001 exchanged substantially all their assets for stock in Medtronic Puerto Rico Operations Co. (MPROC) in a section 351 exchange.

The IRS explained its implied intangible transfer theory as it applied in Medtronic in a June 2016 second amended opening brief filed with the Tax Court, in which the agency argued that the lopsided allocation of profit between Medtronic’s U.S. entities and MPROC implied that the 2001 section 351 exchange must have involved an outbound transfer of intangible property.

By invoking section 367(d), which mirrors the section 482 regulations in key respects, the IRS argued that the U.S. transferors should be treated as having sold the transferred intangible property in exchange for royalty payments over the course of the intangible property’s useful life.

“Respondent’s primary position is that petitioner’s transfer pricing under section 482 was not arm’s length. If the court were to treat petitioner’s transfer pricing as arm’s length, concluding that MPROC is entitled to almost two-thirds of the profits from the [cardiac rhythm disease management] and [implantable neurological device] businesses, then it is a fact that the value of the newly formed MPROC did not appear out of thin air, but had to be a result of a massive infusion of intangible assets at its inception,” the brief says. “Under this alternative position, section 367(d) requires income inclusions attributable to the outbound transfer of intangible assets transferred by a U.S. transferor.”

In making its alternative section 367(d) argument in the 2016 brief, the IRS highlighted the skewed allocation of profit caused by Medtronic’s CUT method analysis more than the reliability of the method under the section 482 regulations.

Regardless, the implication is that MPROC had no realistic way to acquire the kind of intangibles that would disqualify its selection as the tested party in a CPM analysis unless it had been the transferee of high-value intangibles.

The corporate reorganization that established MPROC, the licensee in the transaction that lies at the center of the case, as the entity responsible for all of Medtronic’s Puerto Rican manufacturing operations was a logical place for the IRS to look for that transfer.

It would be an overstatement to suggest that there is an ironclad link between intangible ownership as it relates to the selection of the tested party under reg. section 1.482-5 and the existence of an intangible transfer subject to section 367(d).

Owning intangibles is significant under the CPM because it presents a practical comparability problem, and there is no reason to assume that the “valuable intangible property or unique assets” referred to in reg. section 1.482-5(b)(2)(i) are aligned with the definition of “intangible property” for purposes of section 367(d).

The CPM regulations’ specific reference to “unique assets” casts particular doubt on any such assumption, as it suggests that items other than “intangible property” may disqualify the owner from selection as the tested party.

However, these technical distinctions do not fundamentally undermine the logic of the IRS’s implied transfer argument. Although its motion was denied, the IRS highlighted that logic when it requested leave to file an amended answer during the second Medtronic trial.

The IRS contrasted Medtronic’s expert witness testimony, which suggested that MPROC’s high returns were attributable to its ownership of unique manufacturing know-how, with the terms of the MPROC license and Medtronic’s earlier claim that no transfer of assets covered by section 367(d) ever took place.

“We have seen no explanation for how that [ownership] occurred, and it seems very inconsistent with petitioner’s statement in its brief in the first trial that MPROC had no intangible property, and there was no intangible property for which other intangibles — goodwill, going concern value, and workforce in place — could attach,” Jill Frisch of the IRS Office of Chief Counsel argued during the second trial. “Under the petitioner’s intercompany license, all know-how is owned by Medtronic Inc.”

Enter the TCJA

Whatever its merits, the IRS’s alternative section 367(d) argument hasn’t fared well in litigation to date. The Tax Court rejected the argument in Medtronic and Eaton, largely because it wasn’t specific about the nature of the transferred intangibles or their value.

“Respondent did not specifically identify any intangibles or explain the specific value of any intangibles that should be covered by section 367(d) and what an appropriate arm’s-length charge would be for the use of the intangibles,” the Medtronic opinion explains. Nearly identical language appears in the Eaton opinion, which observes that “respondent did not specifically identify any intangible or explain the exact value of any intangibles that should be covered by section 367(d).”

The lack of specificity noted by the Tax Court is evident in the IRS’s June 2016 amended opening brief, which recites every item of property specified in former section 936(h)(3)(B) and then states that the two U.S. subsidiaries that carried out Medtronic’s Puerto Rican manufacturing activities before the section 351 reorganization “would have had certain of these items of intangible property.”

The brief goes on to assert that “MPROC must have received and must now be exploiting valuable intangible assets, like those identified above, or similar items” to justify its two-third share of the profit attributable to Medtronic’s implantable cardiac rhythm and neurological device products.

A key factor that made this vague intangible transfer argument particularly easy to brush aside, in both Medtronic and Eaton, was its tension with courts’ restrictive interpretation of the definition of intangible property contained in former section 936(h)(3)(B) and reproduced almost verbatim in reg. section 1.482-1(b).

Failing to individually identify the transferred intangible assets makes it impossible to verify whether the transferred items were fully or partially covered by former section 936(h)(3)(B), and pre-TCJA law required deemed royalty payments under section 367(d) only for section 936(h)(3)(B) intangibles.

Whether the pre-TCJA definition of intangible property should have been interpreted in this way is debatable, but the pressing need for the IRS to precisely enumerate the transferred intangibles largely reflects a once-critical legal distinction that no longer exists.

According to the Tax Court and the Ninth Circuit, the definition of intangible property that appeared in former section 936(h)(3)(B) and reg. section 1.482-1(b) did not cover goodwill, going concern value, workforce in place, and other “residual business assets.”

One consequence of this interpretation was that value attributable to residual business assets could be transferred in a controlled transaction subject to section 482 or in a section 351 or 361 exchange without compelling the recipient to compensate the transferor for that value.

The problems caused by this somewhat artificial distinction, which arguably allowed multinationals to transfer U.S.-developed intangibles to low-taxed foreign affiliates for far less than their market value, led Congress to eliminate it as part of the TCJA.

The definition of intangible property, which has since been moved to section 367(d)(4), now explicitly includes goodwill, going concern value, and workforce in place, an amendment that could tip the scales in favor of the IRS’s general implied intangible transfer argument. If the definition of intangible property is now broad enough to cover just about anything other than tangible assets, cash, and cash equivalents, then identifying the transferred intangibles with clinical precision seems unnecessary.

For example, the IRS’s claim in Medtronic that “MPROC must have received and must now be exploiting valuable intangible assets” may have been too vague to establish that the transferred items were covered by former section 936(h)(3)(B).

But the circumstances of the reorganization and the terms of the contemporaneous MPROC license suggest that items now covered by section 367(d)(4) would have to have been transferred to justify MPROC’s outsize returns.

It is difficult to see how an entity like MPROC, which had to license the know-how necessary to perform its sole key function, could have been endowed from the moment of its inception with a level of specialized medical device manufacturing expertise that no potentially comparable medical device manufacturer can match. Whether MPROC’s expertise should be classified as a section 936(h)(3)(B) intangible no longer matters.

Demanding the same level of specificity required by the Tax Court in Medtronic and Eaton in cases concerning post-TCJA tax years would also be difficult to reconcile with Congress’s decision to redefine intangible property to explicitly cover goodwill, going concern value, and workforce in place.

These assets differ from patents, trademarks, and other intangibles covered by former section 936(h)(3)(B) in the manner by which their value is measured: As “residual business assets,” the aggregate value of goodwill, going concern value, and workforce in place is equal to the total value of an enterprise minus the value of all tangible assets, separately identifiable intangibles, and any other assets that can be directly valued.

Requiring that the IRS meet the standard of specificity required in Medtronic and Eaton for items that are inherently impossible to specifically value would frustrate the legislative intent behind the amendment.

Logical Corollary?

The IRS is thus on firmer ground after the TCJA in arguing, as it did in Medtronic, that “if petitioner is correct about its transfer pricing, then the source of [a foreign subsidiary’s] ‘off the charts’ profits had to come from [transferred] intangibles.”

To the extent that the controlled transaction is, as is often the case, associated with a corporate reorganization potentially subject to section 367(d), this could offer the IRS a more potent backstop in Medtronic-like cases that arise in post-TCJA tax years.

Even in the absence of any reorganization, the IRS could argue on section 482 grounds that a controlled intangible transfer took place in the absence of a written agreement. Without a written agreement, reg. section 1.482-1(d)(3)(ii)(B)(2) allows the IRS to impute contractual terms according to the economic substance of the transaction.

However, the existence of some tacit intangible transfer is still not quite an inevitable logical corollary of the taxpayer’s selection of method and the resulting allocation of profit in cases like Medtronic and Eaton.

Although reg. section 1.482-5(b)(2)(i) reflects a clear emphasis on ownership of unique and valuable intangibles over other considerations, intangible ownership is not the only possible basis for rejecting an entity as the tested party. Tacitly acknowledging a point addressed in far greater detail by the OECD transfer pricing guidelines, reg. section 1.482-5(c)(2)(ii) notes the need for comparability between the tested party and the uncontrolled enterprises selected as comparables in the allocation of risk.

Although some of Medtronic’s expert witnesses during the second trial may have blurred the distinction between intangible ownership and risk exposure as grounds for rejecting the CPM, the company has portrayed the product failure and product recall risk borne by MPROC as the kind of nonroutine risk exposure that distinguishes it from potential comparables.

The risk associated with MPROC’s sale of a faulty implantable medical device may or may not qualitatively differ from the same risk borne by any of the other medical device manufacturers used in the IRS’s CPM analysis, but highlighting an entity’s exposure to nonroutine risk may at least offer taxpayers an opportunity to overcome what could soon become a much more useful argument for the IRS.