A U.S. Tax Court judge has ruled that the Internal Revenue Service improperly assessed Medtronic a $1.3 billion tax deficiency, finding its allocation of profits between the medical device maker’s operations in the U.S. and Puerto Rico was unreasonable.

In a case that focuses on Medtronic’s transfer pricing — the royalty rates its Puerto Rican subsidiary paid to use its technology — Judge Kathleen Kerrigan also rejected Medtronic’s rates. But the company said her view was closer to its position than that of the IRS.

The tax agency notified Medtronic in 2010 that it underpaid its taxes by $548.2 million in 2005 and $810.3 million in 2006 by attributing too much of its profit to Medtronic Puerto Rico Operations Co. (MPROC). Companies based in Puerto Rico are considered foreign corporations for U.S. corporate income-tax purposes, meaning they pay the local tax and don’t have to pay the full 35% U.S. tax rate until they repatriate the money.

Medtronic argued that it is entitled to overpayments of $184.6 million for 2005 and $397.1 million for 2006.

“Our preliminary review indicates that [the Tax Court’s] decision appears to be favorable to Medtronic on many key aspects of the case, and it appears to be generally consistent with the company’s most likely scenario for resolution that has previously been communicated to investors,” Medtronic said.

As the Wall Street Journal reports, corporations must make transfer-pricing transactions “as if they were engaged in arm’s- length deals between unrelated companies, and allocate income where it is earned, depending on which entity truly generates the profits.”

MPROC agreed to pay an arm’s-length royalty of 29% to Medtronic on its U.S. net intercompany sales of medical
device pulse generators and 15% on its sales of physical therapy delivery devices. The IRS’ expert — who did not distinguish between devices — concluded, however, that MPROC should have paid royalties of 49.4% and 58.9% royalties on sales for 2005 and 2006.

Judge Kerrigan said the expert had shifted too much profit to Medtronic U.S. but she also found the company’s rates were not arms-length.

“[A]n appropriate arm’s-length rate for devices would be 44%” and, for leads, would be 22%, she concluded.

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