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Given the often large differences between weak CUTs and mechanical applications of CPM, debating which is the better method misses the entire point of economic analysis based on the facts and circumstances of the litigation.
On August 16, 2018, the Eight Circuit vacated the June 9, 2016, Tax Court ruling in Medtronic, 122 AFTR2d 2018-5524 (CA-8, 2018), vacating and remanding TCM 2016-112. Many practitioners have viewed this intercompany royalty rate issue as a battle between an application of the comparable uncontrolled transaction (CUT) approach vs. the comparable profits method (CPM) approach as applied by the IRS. As discussed herein, the latter approach suggests an intercompany royalty rate equal to 50% of sales, whereas the taxpayer originally set the royalty rate at 20% of sales. The appeals decision expressed serious concerns with respect to the CUT application, leading some to believe that the court was endorsing the IRS approach.
This author's view, however, is that the appeals court was calling for a more substantive analysis than either the taxpayer or the IRS offered in the Tax Court. There are often large differences between weak CUTs and mechanical applications of CPM. Faced with these differences, debating which is the better method misses the entire point of economic analysis based on the facts and circumstances of the litigation. The usual application of CPM is a flawed application of profits-based approaches, as it ignores the essence of licensee risk-taking in the presence of highly valuable intangible assets. With that said, the IRS is certainly correct to raise the profit-potential issue when the expected profitability in a controlled transaction is substantially higher than the profitability in the third-party transactions that taxpayers offer as alleged CUTs. But it is precisely in these situations when ignoring the role of licensee risk-taking leads to absurdly high results for the intercompany royalty rate.
The first section of this article presents a basic model for splitting residual profits based on the financial economics of leasing and licensing. The second section reproduces the essence of this author's recent blog post on the specific details in the Medtronic dispute. These details are complicated by the Puerto Rican licensee having performed only the assembly function whereas U.S. affiliates performed component manufacturing and distribution functions. The third section...