The U.S. Court of Appeals for the Eighth Circuit has once again vacated and remanded a U.S. Tax Court decision in the long-running transfer pricing dispute between Medtronic, Inc. and the Commissioner of Internal Revenue. This latest opinion, filed September 3, 2025, provides analysis for tax professionals on the application of the best method rule, particularly concerning the Comparable Uncontrolled Transaction (CUT) method, the Comparable Profits Method (CPM), and the use of unspecified methods under Treasury Regulations § 1.482. The case revolves around the appropriate arm’s length royalty rates for intangible property licensed by Medtronic’s U.S. parent to its Puerto Rican manufacturing subsidiary for the 2005 and 2006 tax years.

Factual Background and Procedural History

Medtronic, a medical device company, allocated profits from its class III devices and leads among its U.S. entities and its Puerto Rican manufacturer, Medtronic Puerto Rico Operations Co. (Medtronic Puerto Rico). The allocation was governed by intercompany licensing agreements (the "Technology Licenses"), under which Medtronic Puerto Rico paid a royalty to the U.S. parent for the exclusive right to use intangible property to manufacture and sell the products.

The dispute began with Medtronic’s 2002 tax return, where it used the CUT method to set royalty rates. After an IRS audit, the parties entered a memorandum of understanding setting wholesale royalty rates at 44% for devices and 26% for leads. However, for the 2005 and 2006 tax years, the parties could not agree on the application of this memorandum. The IRS audited Medtronic’s returns, determined that the CPM was the best method, and issued a notice of deficiency.

Medtronic challenged the adjustment in Tax Court, arguing the CUT method was best. In the first trial, the Tax Court agreed with Medtronic that the CUT method was best but made its own adjustments, using an agreement between Medtronic and Siemens Pacesetter (the "Pacesetter Agreement") as the comparable transaction. On appeal, the Eighth Circuit vacated and remanded, finding the Tax Court’s factual findings insufficient to determine if the Pacesetter Agreement was truly comparable and if the best method had been applied (Medtronic I).

On remand, the Tax Court reversed its prior holding. It rejected both Medtronic’s Pacesetter-based CUT method and the Commissioner’s modified CPM. Instead, the court adopted an adjusted version of an unspecified method proposed by Medtronic, which resulted in a 48.8% wholesale royalty rate for both devices and leads. This led to the current cross-appeals.

Court’s Rejection of the Comparable Uncontrolled Transaction (CUT) Method

Medtronic’s primary argument on cross-appeal was that the Tax Court erred in rejecting its CUT method, which was based on the Pacesetter Agreement. The regulations for the CUT method require that the controlled and uncontrolled transactions involve "comparable intangible property" under "comparable circumstances". A critical requirement for comparability of intangible property is that it must have "similar profit potential" (26 C.F.R. § 1.482-4(c)(2)(iii)(B)(1)(ii)).

The Eighth Circuit upheld the Tax Court’s finding that this standard was not met. The court highlighted several key factual findings supporting this conclusion:

Different Profit Potential: The Tax Court found a significant disparity in profit potential, citing an expert report showing that Pacesetter’s average product profit margin under its agreement was 29%, while Medtronic’s was 54% from the Technology Licenses.
Scope of Intangibles: The Pacesetter Agreement licensed only patents. In contrast, the Technology Licenses granted Medtronic Puerto Rico rights to a "full array of intangible property," including not just patents but also valuable know-how, trade secrets, copyrights, technical expertise, and crucial regulatory approvals. The court credited expert testimony that this broader range of intellectual property conveyed significantly more value and profit potential.
Inapplicability of Adjustments: Medtronic argued that any differences in profit potential could be accounted for by adjustments, citing the general comparability standard in 26 C.F.R. § 1.482-1(d)(2). However, the court pointed out that the more specific regulation governing intangible property, 26 C.F.R. § 1.482-4(c)(2)(iii), permits adjustments for differences in circumstances, but mandates that the intangible property itself must have similar profit potential.

Because the property transferred under the Pacesetter Agreement and the Technology Licenses did not have similar profit potential, the Eighth Circuit concluded that the Tax Court did not clearly err in finding the Pacesetter Agreement was not a comparable uncontrolled transaction. Therefore, the CUT method could not be the best method.

Court’s Rejection of the Tax Court’s Unspecified Method

Having affirmed the rejection of the CUT method, the court turned to the Commissioner’s appeal challenging the Tax Court’s adoption of Medtronic’s three-step unspecified method. The Tax Court’s chosen method used the non-comparable Pacesetter Agreement as a "starting point".

The Eighth Circuit found this to be a legal error. The regulations state that 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" (26 C.F.R. § 1.482-4(d)(1)). The court reasoned that if an uncontrolled transaction (like the Pacesetter Agreement) fails the specific requirements of a specified method (like the CUT method’s "similar profit potential" test), it cannot be considered reliable data or a "realistic alternative". The Tax Court’s finding that the Pacesetter Agreement lacked similar profit potential meant it did not provide reliable data for determining an arm’s length price. Therefore, using the Pacesetter Agreement as a foundational element of an unspecified method was impermissible.

Remand for Reconsideration of the Comparable Profits Method (CPM)

The Eighth Circuit then addressed the Tax Court’s rejection of the Commissioner’s proposed CPM. The court found that the Tax Court applied incorrect legal standards and failed to make sufficient factual findings, necessitating a remand on several points.

Product Similarity: The Tax Court rejected the Commissioner’s comparables partly because they manufactured Class I and II medical devices in addition to Class III devices, and their products were in different fields (e.g., orthopedic vs. cardiological). The Eighth Circuit held this overemphasized product similarity, which is less critical for the CPM. Citing 26 C.F.R. § 1.482-5(c)(2)(iii), the court noted that operating profit is less sensitive to product differences than gross profit. The standard is whether the companies are "sufficiently similar" to provide a reliable measure, not identical (26 C.F.R. § 1.482-1(d)(2)).
Asset Bases: The Tax Court concluded the comparables had "fundamentally different asset bases" but failed to make findings on what those differences were, their effect on profits, or whether reliable adjustments could be made per 26 C.F.R. § 1.482-5(c)(2)(iv). The Eighth Circuit specifically noted that the Tax Court itself used the "return-on-assets" profit level indicator in its unspecified method, undermining any outright rejection of the indicator.
Functional Differences: The Tax Court faulted the Commissioner’s comparables for performing additional functions like R&D and distribution, whereas Medtronic Puerto Rico was solely a manufacturer. The Eighth Circuit found this to be an insufficient reason for rejection, explaining that the CPM is designed to account for such differences, as they are often reflected in operating expenses (26 C.F.R. § 1.482-5(c)(2)(ii)).
Product Liability Risk: The Tax Court found that Medtronic Puerto Rico bore all product liability risk but failed to quantify that risk for the 2005-2006 tax years. It rejected the Commissioner’s proposed adjustment without resolving the factual dispute between the parties’ experts over the amount of risk. The Eighth Circuit held that without a specific finding on the amount of risk, it could not properly review the Tax Court’s decision. The Tax Court was instructed to quantify the risk for Medtronic Puerto Rico and the comparables and determine if any differences were material.

Mandate for Further Proceedings

The Eighth Circuit vacated the Tax Court’s order and remanded the case with clear instructions. The Tax Court must:

Re-evaluate the Commissioner’s proposed CPM using the correct legal standards, particularly regarding product, asset, and functional comparability.
Make specific factual findings on the differences in asset bases and the amount of product liability risk borne by Medtronic Puerto Rico and the proposed comparable companies.
Determine if adjustments can be made to reliably account for any material differences found.
Consider the Commissioner’s alternative argument that Medtronic could have replicated the Puerto Rican manufacturing operations itself, and make findings on the time and cost this would entail to assess if it was a "realistic alternative" (26 C.F.R. § 1.482-4(d)(1)).

This decision reinforces a crucial principle for transfer pricing practitioners: data and transactions that fail the specific comparability requirements of a specified method, such as the CUT method, cannot be repurposed as a reliable foundation for an unspecified method. The court’s detailed instructions on remand signal a demand for rigorous, fact-based analysis under the framework of the regulations.

Prepared with assistance from NotebookLM.